Drawdowns and Rallies
Making sense of recent volatility
The S&P 500 drew down 20% through June 30, only the sixth drawdown of that magnitude over the last 50 years. The first half of 2022 saw the Federal Reserve raising rates into a contracting economy to combat decades-high inflation. And technology company valuations, which had reached 1999-style levels, began to correct as COVID profits appeared to be more one-time than permanent.
The economy is still contracting, the Federal Reserve is still raising rates, and technology company valuations are still extraordinarily high. Yet July saw the S&P 500 rally over 9%, the best monthly performance since the COVID vaccines were announced in November 2020. The market rally was led by the most richly-valued technology companies, with ARK Innovation and the NASDAQ gaining 13%, while the more traditional old-economy stocks in the Dow Jones Industrial Average rallied only 7%.
Figure 1: Index Performance in July
Source: CapitalIQ
Long-term government bonds also rallied in July. High-growth technology stocks are theoretically more sensitive to long-term discount rates: valuations should rely more on cash flows far in the future, while value stocks depend more on current cash flows. The market’s logic appeared to be that an economic slowdown would put a damper on inflation and that the Fed would therefore not have to hike rates as much, and that technology stocks therefore deserved higher valuations.
The question on everyone’s mind is what happens next. Does this rally mean this contraction is over? Or is this a false signal preceding further losses? We looked at 50 years of bear markets in the S&P 500 to develop a sense of historical probabilities. The below chart shows how many days it took the S&P 500 to recover after it entered a bear market (a 20% drawdown) and the further drawdown from that point.
Figure 2: Months to Recovery and Further Drawdowns after a 20% Decline in the S&P 500
Source: CapitalIQ
Upon entering a bear market, it often takes the market a long time to claw back to positive and, with rare exceptions, there are subsequent severe drawdowns. If we are truly staging a recovery out of a bear market, it would be one of the fastest and least severe bear markets in history.
Today, even after July’s rally, high-yield spreads remain elevated. Spreads today are still around 500bps, well above the 10-year median. And as we noted in a recent piece, spreads this wide tend to be very dangerous times for equity investors. Every equity drawdown of -30% or more has occurred within six months of high-yield spreads crossing the 10-year median of 430bps. As Ben Bernanke highlights, credit markets amplify and propagate shocks to the real economy. Within this framework, deteriorating credit market conditions—such as increases in insolvency and rising real debt burdens—feed back into the economy, which in turn worsen credit conditions.
Figure 3: HY Spread Level vs. S&P 500 Max Drawdown, 1954–2000
Source: FRED, Bloomberg
Investors may have sighed a breath of relief in July after months of pain. And perhaps we have already seen the market’s 2022 lows and this recovery will follow the rapid pace of 2020. But a broader set of base rates suggest there’s reason to be cautious, that risk is still elevated, and that we might yet experience an even more significant drawdown.