Investors may have opportunities to buy the dips in the stock market

The downdraft in stock markets in August, when US equities dropped 8% from the highs the previous month, may have been a warning shot, according to Christian Mueller-Glissmann of Goldman Sachs Research. While markets have mostly recovered since, the speed and drivers of the equity decline signal that there’s a higher risk of further setbacks.

“It shows that you're entering a more fragile macroeconomic backdrop,” says Mueller-Glissmann, who heads asset allocation research within portfolio strategy. “For the first time in a long time, you have more concern about growth. And when you have concern about growth, that can drive larger equity drawdowns, because equities are very sensitive to growth.”

The US labor market has softened, and global manufacturing data is showing signs of more weakening. China’s economy is sputtering, and consumer spending in Europe has been lower than some economists expected. “That has broadly increased equity fragility,” Mueller-Glissmann says.

But that doesn’t mean it’s time for investors to be bearish and avoid stocks. While equity declines are becoming more likely, those declines, or dips, could be an opportunity. “Ultimately, we would want to buy the dips as they occur, he says. “The August dip was obviously an opportunity to buy in hindsight, with equities just making new all-time highs.”

The risk of a bear market is still relatively low

Mueller-Glissmann’s team uses a framework using macroeconomic and market variables to assess the likelihood of a major bear market in equities, or drop from peak to trough, of more than 20% over 12 months, as well as the risk of a shorter-term hiccup, or correction, of about 10%.

“This is really helping you to answer the question of whether you want to buy a dip,” Mueller-Glissmann says of the model.

Right now, the team’s research indicates the risk of a stock market drawdown has increased “a bit,” he says, as a result of negative growth momentum and slightly elevated stock valuations. That’s counterbalanced by a positive equity price momentum in the last 12 months, which reflects solid macroeconomic conditions. “These macro conditions usually linger — they don't disappear overnight,” Mueller-Glissmann says. “A strong positive trend in equities tells you the risk of an imminent bear market is low, because it usually takes time for macro conditions to deteriorate from such a healthy starting point.”

Even more importantly, inflation momentum has been declining for more than a year.

The US Federal Reserve reduced its policy rate in late September by 50 points to 4.75%-5%, showing the central bank is increasingly focused on economic growth, as opposed to stamping out inflation. Policymakers have scope to reduce interest rates to support the economy.

“You can have a correction, but most likely the central bank will step in and buffer the equity market and the economy,” Mueller-Glissmann says. “The Fed put reduces the risk of an equity bear market, though it cannot reduce the risk of an equity correction.”

Mueller-Glissmann’s team is “mildly pro-risk” in portfolio construction for the coming 12 months. Financial markets are “early in the late cycle” of economic growth: unemployment rates are low, profit margins are relatively high, and risk premiums for financial assets are low, for example. “All of those are typical late cycle tendencies,” he says.

Stocks should get some support because consumer and corporate balance sheets are in good shape. The savings rate for European consumers is very high, around 15%, and companies haven’t increased their debt burdens significantly. And while inflation seldom surges early in the economic cycle, that’s exactly what happened following the Covid pandemic amid supply-chain bottlenecks and pent-up demand. That resulted in a jump in interest rates, which prevented a build-up of leverage among consumers and businesses.

“There's re-leveraging potential left in the private sector that can drive growth,” Mueller-Glissmann says. “When you're early in a late cycle backdrop, which can last a long time, you want to be modestly pro-risk in your asset allocation, because equities are an asset that can still deliver good returns in these periods.”

Corporate credit, by contrast, can be a more difficult proposition. The extra yield relative to Treasuries is already low, and credit investors are still exposed to recession concerns.

The outlook for the 60-40 portfolio

Many safe-haven assets have already rallied going into the recent dovish Fed meeting. That may make some of them less likely to cushion a portfolio. But even so, Mueller-Glissmann sees scope for US government bonds to provide some buffer to stocks. Economic conditions could be conducive for the traditional 60-40 portfolio, which is split between stocks and Treasury bonds.

“The equity-bond correlation from here should be more negative,” he says. “This is consistent with the market shifting from inflation as a concern towards growth as a concern, and that means there is more benefit of 60-40-type portfolios.”

But with potentially a smaller buffer from long duration bonds there is more value in alternative safe havens such as gold investments. Stocks with defensive characteristics could also be more valuable at this point in the economic cycle, as may some strategies using option overlays.

Overall, Mueller-Glissmann says it isn’t the time to completely avoid risk in portfolios. “Correction risk is probably a bit elevated, but bear market risk seems quite low,” he adds.

This article is being provided for educational purposes only. The information contained in this article does not constitute a recommendation from any Goldman Sachs entity to the recipient, and Goldman Sachs is not providing any financial, economic, legal, investment, accounting, or tax advice through this article or to its recipient. Neither Goldman Sachs nor any of its affiliates makes any representation or warranty, express or implied, as to the accuracy or completeness of the statements or any information contained in this article and any liability therefore (including in respect of direct, indirect, or consequential loss or damage) is expressly disclaimed.