The Anatomy of a Downdraft

In my 30-year experience in the investment markets, I have encountered more equity downturns than I care to remember. There are three categories of equity pullbacks in varying degrees of severity: technical, cyclical and systemic.

Technical pullbacks, the most benign of the three, are corrections. When equity valuations get out of line with fundamentals, like earnings and dividends, prices correct accordingly. Technical pullbacks, while disturbing, are generally short-lived with the bottoming process occurring over a period of days or weeks. Corrections are often spurred by seemingly unrelated news. The blowback is generally isolated to stocks or a few equity sectors. The market’s reaction to the Brexit vote in 2016 was a technical pullback. Technical pullbacks, due to their sharp and short nature, are virtually impossible to anticipate and just as impossible to react to.

Cyclical downturns are more closely associated to bear markets. As expansions evolve, capacity for production and labor tighten up, putting upward pressure on prices and wages. Bond investors, anticipating increasingly aggressive monetary policy, push short-term rates above intermediate rates, creating an inverted yield curve. Credit conditions tighten as lenders worry about the credit worthiness of their borrowers and equity prices fall in response to lowered profit forecasts. The bursting of the tech bubble in 2000 marked the beginning of a cyclical downturn. The S&P 500 shed nearly half of its value between July 2000 and September 2002. Cyclical downturns are easier to spot, take longer to play out and allow agile investors to get out of the way.

Systemic downturns are the most severe of all pullbacks. Systemic downturns represent a general loss of confidence in a country’s financial or political system. This perceived loss of control precipitates a credit contagion and complete loss of liquidity. The Crash of 1929 and the financial crisis of 2008 represent these once-in-a-generation events that were only turned around by extraordinary policy measures. While it took five years for the S&P 500 to recover from the financial crisis, it took more than 15 years to regain the ground lost from the 1929 crash. Systemic downturns often give off early warning signs. Credit conditions, for example, tightened in the fourth quarter of 2007; four quarters before the equity fallout ensued.

We assert that the February pullback is merely technical. Market valuations are expensive and need to correct. At the same time, credit conditions remain robust as the availability of money to borrow, spend and invest is strong. Credit conditions were steady throughout the 1,600-point plunge last Friday and Monday. While it’s impossible to predict where the markets will meander on a day-to-day basis, we are confident that any pullback that plays out over the next few weeks represents a better opportunity to buy for the long run rather than a reason to sell.