To say 2022 has been a tough year for markets would be an understatement. At the time of writing, most major market indices are down over 10% year to date with the tech-heavy NASDAQ index feeling the most pain, down nearly 30%. Closer to home, markets have been slightly more favourable (although the negative 4.12% return on the JSE All Share Index is hardly something to celebrate). Additionally, high inflation numbers across the globe have meant that real returns have been abysmal over the past 10-12 months. Reasons for this poor market performance have been well documented: Inflationary pressures (and the subsequent rate hikes associated with this), supply-side constraints in Europe brought about by the Russia/Ukraine conflict, political upheaval in the UK and the worst loadshedding on record in SA, to name but a few. However, as we enter 2023 it is important to consider what may drive market performance next year and whether the worst is indeed behind us.

Taking a very simplistic view, there are two common types of bear markets. The first one I’ll explain is the ‘shock’ or ‘event-driven’ bear market. Examples of this would be events like 9/11 or the COVID lockdown. These are essentially events that nobody saw coming and that had a massive detrimental effect on the world and economic activity. These types of bear markets are often seen as the most dangerous as policymakers (and the general public) are often unsure of how to respond, leading to mass panic and huge drawdowns in the equity market as people flee to safe-haven assets such as cash. However, although scary, these bear markets are generally steep and short – often characterised by huge losses but where the market recovery is also rapid and material.

The second type of bear market is what is known as a cyclical bear market. Cyclical bear markets are associated with a normal business cycle fluctuation. This is where central banks monitor, supervise and make adjustments to our monetary and financial policy as needed in an attempt to keep things safe, flexible and relatively stable. This monitoring and controlling element means central banks will intervene to raise rates as they see necessary, thereby controlling prices. Let us cast our minds back to the end of 2021 or the beginning of this year. Central banks around the world knew that there would be inflationary pressures coming out of COVID due to the hefty stimulus pumps granted in 2021. These stimulus pumps had huge economic benefits but also fuelled inflation. Central banks knew this and had plans in place to curb inflation. Generally, it was thought that there would be a bit of market pain and then inflation would be under control. However, this all changed on 24 February 2022 when Putin invaded Ukraine. The short-term effect of this was market panic as the debate around a potential nuclear war gathered steam. This however died down relatively quickly. The real concern though was that this invasion exacerbated inflation around the globe as massive supply-side constraints emerged, causing inflation (particularly in developed markets) to spiral out of control. It is for this reason that this particular bear market has been so pronounced – the effect of the Russia/Ukraine conflict caught central bankers unaware and they have been playing catch up ever since.

It is extremely difficult (perhaps close to impossible) to accurately determine when a bull or bear run will end. In a perfect world, investors would always sell at the peak of a bull run and buy up at the trough of a bear run. However, this is simply not realistic. Take the month of October for instance. There was no materially positive news flow in October yet markets still ran 7% - one of the best months of the year in terms of performance. This suitably illustrates the risk you run when trying to time the market. If you exit markets to sit on the side lines and wait for better market conditions, you can easily miss a major move. However, if timing the market is so difficult, and the appropriate advice is to stay invested through this bear market, then the question remains when will the tide start to turn? The answer is that, typically, a signal for the turning points in bear markets is when prevailing news is overwhelmingly pessimistic and there is a total absence of optimism – essentially the point of maximum pessimism.

The theory surrounding “the point of maximum pessimism” is that after a sustained period of anxiety and “bad news” markets get into a state of despair and begin to react too negatively to even the slightest bit of bad news. This can cause mispricing and opportunity for investors who are willing to look through the “noise” and take a medium-term view on markets. One of the key aspects of this stage in a market cycle is that if news flow starts to turn, and you start to get some upside surprises (i.e. news that is better than is expected), you can find that markets can reassess the assumptions that have been priced in, and can react swiftly. We saw an example of this last week – inflation in the US was expected to come in at 7.9% but came in at 7.7%. This caused markets to reassess assumptions on what interest rate policy would do (i.e. that interest rates may not go as high as expected or stay as high for as long as markets had been anticipating) and immediately markets took off. We saw a 6% move in A DAY on the S&P500 – an extraordinary movement. What is interesting to note is that 7.7% inflation is not a good number – it is a massive increase in CPI. However, it wasn’t as bad as markets were expecting and is indicative of the inflationary cycle having peaked.

Another powerful example of this can be seen in the form of Netflix’s share price over the last year. During the first quarter of 2022, Netflix lost over 200,000 subscribers and forecasts showed an anticipated loss of over two million more subscribers in Q2. The share price plummeted over 37% almost immediately off the back of this news. However, in actuality, there was only a decline of around 970 000 subscribers in the second quarter. Whilst this is a major decline, it was less than the market anticipated and the result was a share price bounce of 28% over the next month - again illustrating how news does not need to necessarily be good in order for the market to react positively. Rather that news just needs to be better than expected.

Again, determining the exact point of maximum pessimism is a tough exercise. There are indeed many risk factors surrounding the economy at the moment. Recessionary risks, the protracted conflict in Ukraine and South Africa’s electricity supply are obvious ones and we must acknowledge the difficulty in predicting when or how these issues will be resolved. However, there are some signs that the point of maximum pessimism may have passed. There are some good signs of inflation cooling with the oil price down from $122 in June to around $85 at the time of writing. Furthermore, freight rates, which are an excellent indicator for global inflation, have reduced nearly 40% since August.

It must be reiterated that timing the market is exceptionally difficult to do and this is why most advisors strongly advocate for investors to hold on during times of volatility. However, what we can do is look for those market signals that may spell out the potential turning point. Whether these signals are perhaps a month or two too early shouldn’t be a primary concern. The market may well slip a few percent in the next 3-4 months but the long-term view (admittedly off a low base), is starting to look slightly more appealing.

This article was published on Moneyweb, 22 November 2022. To read more from Jono, click here