Is this market on the verge of GAS-ing out?

Many have I loved, and many times been bitten
Many times I've gazed along the open road

—      “Over the Hills and Far Away,” Jimmy Page/Robert Plant

In our mid-year outlook (The Great Pause of 2020), we characterized the most recent market activity — bear market to recovery — as similar to how individuals deal with stress. For a refresher, we believe there are three stages to a bear market and recovery similar to there are three stages as to how we deal with stress.

According to medical research, people respond to stress in similar ways. This is referred to as general adaptation syndrome, or GAS, a theory created by Dr. Hans Selye. GAS typically follows a three-stage process that describes the physiological changes the body goes through when under stress. Selye identified these stages as alarm, resistance, and exhaustion. Alarm is the initial phase that results in a panicked response to the stimuli. Typically, this is the fight-or-flight response to stress. Resistance, the second phase, is when our bodies adapt and learn to cope with the stress. We may feel as if we’re managing the stress well but, in truth, we’re masking the symptoms and can find ourselves in a state of denial. This leads to the third stage — if we remain in the elevated stress level for too long, resistance will lead to exhaustion.

As we look back at prior recessionary bear market cycles and the recovery rallies that follow, we can clearly identify the three stages of GAS and the characteristics that define them. When examining these prior markets, we see that stage 1, alarm, is the bear market triggered by the onset of a recession. Stage 2, resistance (resistance to the present economic realities in favour of future expectations), is the rebound rally off the bear market bottom. Stage 2 is typically characterized by an earnings recession (that follows the economic recession) and results in a rapid increase in price-to-earnings ratio (P/E) multiples as investors price in the recovery. Resistance ends when the market P/E multiple has reached its peak. That brings about the onset of stage 3, exhaustion. The exhaustion stage is characterized by an earnings recovery and a multiple contraction that, when combined, lead to lackluster market returns. We describe the transition from stage 2 to stage 3 as similar to running a 5K race, where you give it your all in the first kilometre but you still have to run the last four — it’s sluggish at best.

These three stages of the bear market cycle are clearly evident during the 1973–74, 1980–82, 2000–02, and 2007–09 recessionary environments (with 1990 being the outlier). In each, we can clearly define each stage.

Following a strong bear market recovery (a new bull market), the market enters an exhaustion phase. This is marked again by a peak in P/E multiples and typically coincides with an earnings recovery. Stage 2 can be short or long. It has ranged from nine to 17 months. But in each case, it ends (and exhaustion begins) with a peak in P/E multiples. It warrants watching whether the new high on the S&P 500 Index was the end of stage 2, in terms of the recent Index level and P/E multiple. Unfortunately, we never know we’ve hit the peak until well after the fact. If we have, then the next two years are going to deliver pretty lackluster returns as we move into an earnings recovery. It’s not a reason to sell equities, merely a reset of return expectations.

It only stands to reason to expect that future equity returns will be somewhat more average to below average following such an impressive rally against a backdrop of a modest economic recovery. In our mid-year outlook, we set expectations for the S&P 500 Index to return 5 to 15% through to the end of 2021, with risk to the upside. Since June 30, the S&P 500 Index, through the new recent high, has gained 9.3%. We believe the market is near entering the exhaustion stage and, therefore, Index returns over the next couple of years are likely to resemble returns through past exhaustion stages. This would put return expectations in the mid-single digits on an annualized basis through to the end of 2021, with risks remaining to the upside on the potential for an accelerated economic recovery.

Passive investing has made it look easy during the current rally but may leave investors disappointed in a sideways market. In such an environment, we believe active management and, in particular, a greater emphasis on security selection will be key to portfolio performance in the exhaustion stage.

1973–75

 

Stage 1 – Alarm

Stage 2 – Resistance

Stage 3 – Exhaustion

 

Market peak

Market trough

Recovery to P/E peak

P/E peak + 12M

P/E peak + 24M (annualized)

Date

1/11/1973

10/3/1974

3/24/1976

3/24/1977

3/24/1978

Index

120.24

62.28

103.42

99.7

89.36

Percent change

 

-48%

66%

-4%

-7%

P/E

19.46

7.5

13.7

10.6

8.56

1980–82

 

Stage 1 – Alarm

Stage 2 – Resistance

Stage 3 – Exhaustion

 

Market peak

Market trough

Recovery to P/E peak

P/E peak + 12M

P/E peak + 24M (annualized)

Date

11/28/1980

8/13/1982

10/10/1983

10/10/1984

10/10/1985

Index

140.52

103.85

172.65

162.11

182.78

Percent change

 

-26%

66%

-6%

3%

P/E

9.12

7.16

13.8

9.97

11.55

2000–02

 

Stage 1 – Alarm

Stage 2 – Resistance

Stage 3 – Exhaustion

 

Market peak

Market trough

Recovery to P/E peak

P/E peak + 12M

P/E peak + 24M (annualized)

Date

3/24/2000

10/9/2002

12/23/2003

12/23/2004

12/23/2005

Index

1527.46

776.76

1096.02

1210.13

1268.66

Percent change

 

-49%

41%

10%

8%

P/E

30.61

17.01

21.68

19.03

17.67

2007–09

 

Stage 1 – Alarm

Stage 2 – Resistance

Stage 3 – Exhaustion

 

Market peak

Market trough

Recovery to P/E peak

P/E peak + 12M

P/E peak + 24M (annualized)

Date

10/9/2007

3/9/2009

12/24/2009

12/23/2010

12/23/2010

Index

1565.15

676.53

1126.48

1257.77

1265.33

Percent change

 

-57%

67%

12%

6%

P/E

17.5

11.13

26.42

16.26

14.11

2020–?

 

Stage 1 – Alarm

Stage 2 – Resistance

Stage 3 – Exhaustion

 

Market peak

Market trough

Recovery to P/E peak

P/E peak + 12M

P/E peak + 24M (annualized)

Date

2/19/2020

3/23/2020

8/19/2020

??

??

Index

3386.15

2237.4

3389.78

??

??

Percent change

 

-34%

52%

??

??

P/E

22.11

14.69

26.44

??

??

Source: Manulife Investment Management, Bloomberg, as of August 19, 2020

AODA: This chart shows a correlation between the S&P 500 Index and the trailing 12-month price-to-earnings ratio through each of the three GAS stages (alarm, resistance, and exhaustion), from 1973 to 1978. As the Index moves up or down, the P/E ratio generally follows the same direction.
AODA: This chart shows a correlation between the S&P 500 Index and the trailing 12-month price-to-earnings ratio through each of the three GAS stages (alarm, resistance, and exhaustion), from 1980 to 1985. As the Index moves up or down, the P/E ratio generally follows the same direction.
AODA: This chart shows a correlation between the S&P 500 Index and the trailing 12-month price-to-earnings ratio through each of the three GAS stages (alarm, resistance, and exhaustion), from 2000 to 2005. As the Index moves up or down, the P/E ratio generally follows the same direction. However, the chart shows a general opposing move between 2004 and 2005 — as the Index went up, the P/E trended down.
AODA: This chart shows a correlation between the S&P 500 Index and the trailing 12-month price-to-earnings ratio through each of the three GAS stages (alarm, resistance, and exhaustion), from 2007 to 2011. As the Index moves up or down, the P/E ratio generally follows the same direction. There’s a strong upward movement in the P/E in the latter part of 2009, but the upward related move in the Index is smaller.

Philip Petursson, CIM
Chief Investment Strategist and Head of Capital Markets Research

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Philip Petursson

Philip Petursson, 

Chief Investment Strategist and Head of Capital Markets Research

Manulife Investment Management

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Kevin Headland

Kevin Headland, 

Senior Investment Strategist

Manulife Investment Management

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Macan Nia

Macan Nia, 

Senior Investment Strategist

Manulife Investment Management

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