Will the equity bounce be short-lived or is the bull market still intact? Our analysis suggests that Eurozone equities tend to go up in the year after a 15% decline. However, the evidence is not overwhelming and the outcome seems to depend upon the extent of the economic slowdown. We think the current rally has legs, helped by ECB support and strengthening fundamentals. We remain buyers on dips….
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Risk assets ended the week higher, building on the recent rebound (see Figure 3). Is this a “dead-cat bounce” or does the rally have legs? Bearing in mind that the MSCI EMU index was at one point (September 24) down 19.7% from its recent high, we have analysed those episodes since 1973 when Eurozone equities declined by at least 15% from a previous peak (using the Datastream EMU index for 1973-88 and the MSCI EMU index thereafter).
Before the current episode, there had been 11 corrections of 15% or more since 1973. Figure 1 shows the range of subsequent outcomes in the year after the 15% decline was first registered, along with the average across the 11 episodes and the to-date performance during the current period. The episode with the weakest subsequent returns (“Lowest”) was that starting in January 2008, not surprising given that the financial crisis was about to hit. That with the best returns (“Highest”) came after May 2012 (just before Draghi made his “anything it takes” speech).
Interestingly, the market was up in the next 12 months in 7 of the 11 cases. The average 12 month gain across the 11 episodes was 5.6% and the median was 15.7%.
Given that we have just passed the 30 trading day point since the market dropped below the -15% mark, it is interesting to note that in the five previous occasions when the market was up after 30 days (as it is now), it was still higher at the full year mark in four of them (with an average 13% 12-month gain across the five episodes). On this basis, we should be encouraged by the rapid rebound in the market.
How does equity market performance relate to economic performance? Using industrial production as a proxy for the economy, we analysed how it accelerated/decelerated in the Eurozone in the year after the equity market reached the -15% point. Figure 2 shows that the year-on-year growth in industrial production was usually lower 12 months after the 15% decline occurred (by 5 percentage points on average). Only one of the periods (from May 2012) recorded a noticeable improvement in growth, from -2.3% to -1.7%, which is hardly impressive. Like it or not, sharp declines in the equity market are often associated with subsequent economic deceleration. Figure 2 also suggests that the subsequent move in equity markets is proportionate to the change in industrial production growth – big declines in equity markets are associated with sharp economic deceleration, though the direction of causality is unclear.
Our conclusion from all of the above is that dramatic declines in equity markets can be followed by further declines in the next year, though this happens in a minority of cases and when the market makes a quick recovery (as it has this time), history points to a tendency for further gains in the months and quartersahead.
We suspect the critical determinant of future equity market performance will be what happens to the economy (Figure 2 suggests dramatic economic deceleration tends to be associated with weak market outcomes). Though recent data flows have been mixed (with weak German production, for example), we believe there is enough momentum in the Eurozone service sector, along with support from ECB asset purchases (see Draghi comments) and cheap valuations, to keep the stock market on an upward trajectory (see The Big Picture, where our Eurostoxx 50 target suggests 14% upside over the next year).
We remain Overweight in Eurozone equities in the Source Multi-Asset Portfolio (currency-hedged) and are buyers on dips. The next important economic data point is Eurozone industrial production for August, which is due on Wednesday.