Correction Detection; the risks of a drawdown within a bull market
* The S&P 500 and MSCI World Index have entered their longest n period without a
correction of more than 5%.
* This has been the strongest start for global equity markets in any year for at
least 30 years, and is even more extreme on a risk-adjusted basis. This
‘melt-up’ has occurred despite the already strong returns last year. The S&P 500
had its second-highest risk-adjusted returns in more than 50 years and MSCI
World ($) had its second-highest risk-adjusted returns since the index began in
1970. The year-to-date sharp rise in equity returns has also continued even as
bond markets are experiencing sharp risk-adjusted losses.
* There remain good reasons to be bullish equities for the year. We remain
overweight and think that bear market risks are low.
* But a correction is becoming increasingly likely. Our GS Risk Appetite indicator is
near its highest level ever, pointing to a sharp rise in optimism. Our GS Bull/Bear
Market Indicator (GSBLBR) is at elevated levels, although the continuation of low
core inflation and easy monetary policy (which are components of the indicator)
suggests that a correction is more likely than a bear market.
* Drawdowns within bull markets of 10% or more are not uncommon (we find 22
since 1945). The average bear market experiences falls of 30% over 13
months and takes 22 months to recover to previous levels (in nominal
terms). The average bull market ‘correction’ is 13% over 4 months and takes
just 4 months to recover.
* 2018 has begun with the S&P 500 and VIX both rising. The increase in volatility
amid a market rally may, in part, reflect increasing risks, and may also reflect a
bullish willingness to spend premium to add to upside exposure. We would buy
the equity market on a correction and, while we recommend being fully invested,
would look to hedge downside risks. Our options strategists have suggested
doing this through various structures, including put spreads.