Make Dispersion & Value Great Again

17 March 2025

Since World War II there have been 48 corrections of -10% on the S&P500 (the global risk proxy), 12/48 (25%) have turned into a -20% or greater bear market. Put another way, 75% have rebounded from the 10% drawdown. The trouble with this type of analysis is that it ignores the valuation starting point. As we often note, the price you pay matters for your future return. The outright price to earnings multiple for the S&P500 was very elevated relative to history and the equity risk premium extremely compressed. In that context, and through the lens of the “reverse feedback loop” – the Administration’s commitment to unwind forever and ever policy, the probability of a larger drawdown might be greater than 25%.

The good news as we have noted over the past two weeks is that sentiment has become too pessimistic on a range of tactical and positioning indicators. For example, the AAII survey is at levels consistent with the larger drawdowns in 2020 and 2022. The correction has been orderly, so far, without a large impulsive increase in volatility or de-leveraging. The vol specialists would say that the truly wingy stuff in the S&P surface for June, August and September has been pushed down from all-time-high spot levels. Index spot implied volatility and credit volatility are still very well behaved compared to previous episodes (chart 1). The correction has clearly been much larger in the major technology stocks (approximately -20%).

Chart 1

As we have noted, the reverse feedback loop is not just about the economics, but also the link between liquidity, leverage, and volatility. Gamma works in both directions. The crowding and concentration in the US mega-cap technology companies in global portfolios has potential to create a negative gamma like downside accelerator. Higher-beta stocks have corrected a lot more and have the most potential to rebound or amplify the vol episode if the sell-off accelerates.

Investors have priced the market unfriendly elements of the Trump policy Agenda – tariffs, destabilising alliances, and reduced labour supply – first. The growth-positive policy – tax cuts, de-regulation, and lower rates - will arrive later in the year. ISM new orders – a decent coincident indicator of earnings revisions and momentum has trended higher since the 2022 low. However, new orders corrected back below 50 (expansion/contraction level) in February (chart 2).

Chart 2

Arguably the correction in equity prices brought markets back into line with the macro news flow on growth. Other measures of consumer and business confidence also remain fragile. Counterintuitively larger growth fears or evidence of stress in the credit and funding markets, might lead to lower rates/yields and ease broad monetary and financial conditions.

The good news in Asia and Emerging Markets is that the Donald has made dispersion and value great again. MSCI China has outperformed the S&P500 by 24% so far year to date. Of course, the S&P500 has outperformed by 215% over the past decade. Moreover, on a relative price or valuation chart you must squint hard to notice the recent performance (chart 3). The forward-looking point is that relative valuation is back to Asia crisis levels or a very traumatic period in economic history in the region. US outperformance has been warranted by superior earnings for the past 16 years. The valuation starting point suggests improved odds of an EM relative recovery, especially if the dollar has peaked. We also note the additional policy support in China today.

Chart 3

20251703_Make_Dispersion_And_Value_Great_Again.pdf

Download PDF • 270KB