Trends in Equity Markets

What Panic Says about the Future

The S&P 500 entered bear market territory in April. The VIX hit 60—a fear level matched only during the GFC, Covid crash and last summer’s yen unwinding. Such an extreme spike tempts our contrarian instinct.

Since 1990, there have been 13 VIX spikes above 40—a severe panic threshold. Ten of the 13 were followed by gains over the next 12 months.

The worst of the three losing experiences was a 14.6% drop post-9/11. Even buying after the first Global Financial Crisis (GFC) spike to 40 only led to a 1.5% decline in equities in the following 12 months. Last summer’s “Yenmageddon” also only led to mild losses in the last eight months of about 2%. Still, the median one-year return across all episodes was 25.1%.

With the VIX hitting 60 this spring, it’s worth recalling how bold that is. Back in 2008, a VIX at this level came alongside images of bricks flying into Wachovia ATM vestibules. The Tariff Tantrum has people spooked, but this isn’t exactly Lehman employees with their cardboard boxes or homeowners mailing the keys back.

There’s more for the bulls, who are now feeling awfully alone. The American Association of Individual Investors (AAII) survey just posted its third-highest bear count since the survey began before the 1987 crash. The only two higher readings: October 1990, post-Kuwait invasion, and March 2009, the GFC low.

No question, the tape has looked shaky. For one, high-yield spreads have widened, and that’s on top of a Treasury market that has become erratic.

But the Fed’s Loan Officer Survey shows seven straight quarters of easing. When this indicator is on the mend, it usually precedes stronger labor markets and earnings growth. That matters, because the Street is over its skis on 2025 estimates for the S&P 500, with 11% year-over-year (YoY) growth in the forecast. If that happens, the market’s forward price-to-earnings (P/E) ratio is 18.6. But revisions to the $269.49 FactSet earnings per share (EPS) estimate seem likely. Using instead the 2024 P/E, $243.02, the multiple is 20.6.

Plenty of investors are heading for the hills—but history’s whispering, not screaming. Volatility this intense hasn’t been a cliff; it’s been a springboard. Every time the VIX hits these levels, we treat it like a five-alarm fire. But maybe it’s the gift that shows up dressed like risk.

“Volatility this intense hasn’t been a cliff; it’s been a springboard.”

History Rhymes, but Valuation Pays

It’s been a poor doom predictor in recent years, but the market’s cyclically adjusted price-to-earnings (CAPE) ratio at 35.6 is hard to ignore. Only two periods have exceeded this: the 1999 and 2021 peaks. Before the recent surge, 1929’s 32.6 held the bronze. Today’s valuation begs us to consider downside possibilities in portfolio construction.

This is one reason we remain over-weight in Value over Growth. Despite Value outperforming Growth by 700 basis points (bps) this year to date, we believe now is not the time to chase story stocks. Those live in Growth portfolios.

Small caps offer a major relative valuation opportunity. They’ve tested the faith of every Fama & French disciple—including us—but even dogs have their day. Reported earnings show the S&P 600 at a 23.5% discount to the S&P 500. We’ve seen discounts this steep in 1973, 1976, 1998, 2001 and 2020. Outperformance followed in 1974–1981 and 1999–2018. A third act may be near.

As summer approaches, nerves may settle—letting the market revisit pre-Tariff Tantrum themes. One is the potential for a “peace dividend” from a Ukraine ceasefire.

WTI crude was $123 three years ago—now it’s less than half that figure and tumbling. Not exactly a stagflation backdrop. AI’s labor-saving story has been drowned out by tariff headlines. It’s a real theme—and a strong counter to the stagflation crowd.

Trump made several tax cut promises on the campaign trail, including eliminating taxes on tips, overtime and Social Security benefits and an extension of the 2017 tax cuts. He’s also floated relief on SALT deduction. Should these policies become law, they could offset tariff stress.

Meanwhile, China is rolling out fiscal and monetary stimulus. It recently injected $72 billion into its largest banks to boost lending. Since October 2022, its central bank balance sheet has expanded by $1 trillion—a COVID-era dose of stimulus.

On the flip side, a new market fear emerged at the beginning of the year: that Elon Musk’s Department of Government Efficiency would cut federal spending. For an economy hooked on stimulus, that’s a curveball. But we have an offset: Germany, so-recently notorious for its “Black Zero” budget deficit-to-GDP ratio target, is rolling out a €500 billion multi-year plan for infrastructure and defense. G7 neighbors France, Italy and Spain are on the same page.

That comes alongside two straight quarters of positive firm credit demand in the Euro Area Lending Survey. Historically, positive turns in this metric have often led eurozone recoveries.

“Small caps offer a major relative valuation opportunity.”

While the U.S. Wobbles, Japan Reforms

While Europe figures out its next move, Japan remains our top international play. Consider this: the Topix trades at 12.3 times this year’s earnings. That implies an 8.1% earnings yield. Now assume earnings fall 25% short of consensus. That still leaves a P/E of 16.4—or a 6.1% yield. Meanwhile, 10-year Japanese government bonds yield just 1.12%. Even in the bear case, equities yield five percentage points more than bonds. If earnings hold up, the spread is seven points.

These figures contrast sharply with the arithmetic in the U.S., where the earnings yield on 2025 Street estimates is 5.37%, barely clearing the bond yield—and the CAPE is flirting with all-time highs.

Away from Trump headlines, Japan is making not-so-quiet moves. It’s reaffirming trade ties with China and South Korea. Wages are up 3.1% YoY, though inflation is creeping higher. Bank of Japan rate hikes now appear to be off the table. And Japan’s key bullish driver—corporate governance reform—is ongoing. Buyback pledges jumped 75% last year; board reform proposals rose 67%. Even with ho-hum growth, there’s plenty to like in Japan. We remain over-weight.

Fear is on page one. Valuation is buried on page nine. But when the VIX hits 60, history tends to side with page nine. Fear sets the table. We’re showing up hungry—over-weight Value and Japan, with small caps on the watchlist.