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The grapes of patience

During a bear market, the collapse of prices squanders capital, and time tests the nerves and patience of investors. Nine months after the first week of January when Jerome Powell decided to bury the era of negative real rates, portfolios are still undergoing one of the most violent tests of the last 120 years. 
 
You have to go back to the Great Depression of the 1930s, Pearl Harbour or the oil shock of the 1970s to find memories of such a brutal massacre of the diversified portfolio. In 2022, a 60/40 allocation to S&P500 equities and US Treasuries will lose over 21%. In 2008, 14%. In 1969, 7%. At the advent of the Pacific War, nearly 9%. Two years after the 1929 crash, 27.5%. Rarely outside these extreme episodes have fixed income assets and equities been so correlated in their fall. 
 
And yet, as the indices record new lows, the S&P500 risk premium is surprisingly unrewarding. At 2%, it is more than one standard deviation below its 20-year average. 
Until September, the compression in excess equity earnings was primarily driven by rising rates. Now that the work of downward earnings revisions has begun with the string of earnings warnings in recent weeks, the deterioration in corporate fundamentals is likely to add fuel to the fire for sellers. The significant drop in dividend futures is probably a sign of the extent of the corrections that analysts will apply to expected results for the coming quarters. 

It is probably this worrying observation that caused the bloodletting in the week leading up to the long-awaited US inflation figures in September. 89 billion dollars of risky assets were sold in favour of replenishing portfolio liquidity…
 
The positioning and sentiment indicators confirm this historical pessimism. However, these technical parameters alone cannot justify an aggressive return of risk in allocations. At best, they presage bear market rallies that should allow portfolios to be repositioned, as in August, rather than giving in to the momentary and dangerous enthusiasm of these market phases that exacerbate investors’ emotional biases. 
 
The day of 13 October, during which the markets oscillated between the euphoria of a fall in British rates and the terror of a higher than expected inflation figure before ending up 4% higher following the strong rebound of the American indices, is a reminder that volatility evolves at extreme levels, which deprives any buying signal of its statistical robustness. 
Of course, for the most optimistic investors, the question is not if but when inflation and rate hikes will show the first signs of abating. Nevertheless, the wait for these markers of a market low may be longer than expected. The onus is still on the markets to abandon the idea of a Fed rate cut as early as 2023 and purge themselves of the pipe dreams that have haunted them for too long… It is at this point of extreme distress, when the fewest optimistic voices are raised, that the fruits of patience can be harvested.

Thomas Planell, Portfolio manager – analyst at DNCA. This article was finalised in October 14th, 2022.

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