Every share market correction throws up opportunities to pick up some bargains. And while those opportunities can make a significant difference to a portfolio, any investment will be tinged with trepidation that the correction isn’t yet over, and no sooner will the buy button be pressed than markets suffer another leg down.

Whilst there is absolutely nobody on the planet that can be certain, a very sound argument can be made that, on the balance of probabilities, it is likely we have seen the bottom in this current correction. That one sentence contains three caveats, which is to underline that no matter how sound the argument appears to be, it is no more than conjecture.

First, that call is much braver in relation to the US market than the Australian, which has benefited enormously from a relatively large weighting in commodity-related companies. Given the US’s influence on global financial markets, this argument focuses on the US.

JP Morgan points out the average share price decline of US stocks to the recent low on 8 March is pretty comparable to past large corrections, as long as the economy doesn’t go into recession. For instance, the average share price decline in the S&P 500 was about 22 per cent (note, that’s different to the decline in the overall index, which was just under 14 per cent), compared to the average seen in previous large selloffs of 28 per cent. For the much broader Russell 3000 the average stock fell 36 per cent this time versus previous averages of 34 per cent, and for the NASDAQ it was 48 per cent this time versus 41 per cent previously.

The catch is if a recession occurs, the average share price decline for the S&P 500 is 46 per cent, for the Russell 3000 it’s 55 per cent and for the NASDAQ it’s 59 per cent. So the question is whether the US likely to recess?

ClearBridge Investments publishes a Recession Risk Dashboard, comprised of 12 different variables that is updated monthly. At the end of March only one of those variables was flashing red, and one was yellow. Over the past eight recessions, the average was nine red indicators and one green.

Source: ClearBridge Investments

But what about the much discussed ‘inverted US yield curve’, which is where the yield on a shorter dated government bond is higher than a longer dated one, indicating the bond market expects growth to slow between those periods, and the fact every US recession for the past 50 years has been preceded by such an inversion?

Critically, there are dozens of different US government bonds and a myriad of different yield curve relationships. The focus, and noise, has been on the 2-year/10-year bonds, where the gap was recently the lowest in 15 years. However, the most reliable recession indicator is the 3-month/10-year curve, where, at the same time, the gap was at its highest positive differential in 15 years.

Bespoke Investment Research of the US points out that, based on historical data, the 3-month/10-year yield curve implies a less than 5 percent likelihood the US will be in recession in 12 months’ time.

Source: Bespoke Investments

It also pointed out that currently about 5 per cent of the possible yield curves are inverted, whereas going back to the 1970s, it’s hit about 80 per cent prior to a recession. That is not to say a recession is impossible, but it seems unlikely.

Source: Bespoke Investments

In any case, for share prices to suffer the extra leg down, the economy needs to be either in, or on the cusp of, recession. Over the last five recessions (not including 2020, where the government pulled the plug on the economy) the average gap between the US yield curve first inverting and the economy recessing was 17 months, and while those recessions did coincide with significant declines in the S&P 500, the average gain between the yield curve inverting and the market starting to decline was a massive 43 per cent.

Not surprisingly, when Professors Eugene Fama and Kenneth French undertook a study of the predictive power of yield curve inversions they found there “is no evidence that inverted yield curves predict stocks will underperform Treasury bills for forecast periods of one, two, three, and five years.”

A final indicator is the AAII (American Association of Individual Investors) Sentiment Survey, which is based on a weekly poll of its more than two million members. The proportion of respondents who are bullish about the market outlook over the next six months fell to less than 16 per cent, which is one of its 10 lowest readings since inception in 1987, and the lowest level in almost 30 years.

This is recognised as a strong contrarian indicator. US investment group, Jefferies, looked at the S&P 500’s performance after the ‘bull-bear spread’ (the bullish sentiment reading minus the bearish) dropped below -30 and found the average six-month return is 8.3 per cent and was positive 91 per cent of times (if you take out the GFC it was 12.6 and 100 per cent respectively).

The thing is, even if global share markets have seen the bottom for this correction, that doesn’t mean they will look the same as they did. For now at least, inflation has re-entered the investment equation and central banks are threatening multiple interest rate rises, which could see a change in the kind of companies that outperform. Smart Investors would do well to be mindful of the balance between ‘growth’ and ‘value’ stocks.

So where should you look for those bargains? Despite suffering their worst quarterly return in 40 years, bonds are still trading in the 70th centile of their historical valuations (i.e. they are expensive), whereas equity markets are around their 60th, and if you exclude the US, they’re in their 20th. So non-US equities appear to be cheap.

Indeed, if you use a very basic measure like the next 12 months’ price to earnings ratio (PE), Europe is as cheap as it’s ever been versus the US. 

While technically the US still has much of the momentum, there’s an old saying in financial markets that ‘trees don’t grow to the sky’.

One area that is more value oriented is resources and commodities, which Australia obviously benefits from. The CRB (Commodity Research Bureau) Index, which covers a broad range of commodities, has risen 28 per cent year to date, and 62 per cent over the past 12 months.

The current correction, like all before them, is definitely throwing up some bargains. The most common risk investors face is waiting for clarity before investing. Financial markets always involve uncertainty, and by the time things are clearer, those bargains are likely to be long gone.

In times of geopolitical risk, it’s understandable that investors’ thoughts turn to what effects it will have on a carefully nurtured portfolio and whether there are ways to protect it.

That kind of protection is referred to as a “hedge” – ideally it will increase in value at times when markets are vulnerable to a fall in risk assets, such as equities.

There are many assets that can act as a hedge – for example, investing in real assets like property or art can provide a return that has no correlation to shares. However, not all portfolios are large enough to be able to diversify into expensive assets like these.

For more average-sized portfolios, the most commonly used hedges are those that trade on financial markets, such as gold, government bonds or the US dollar. All three can be accessed through ETFs that trade on the ASX.

However, there is no guarantee that what looks and sounds like a sensible hedging strategy will work. It can end up costing money.

The accompanying table looks at 12 of the most significant geopolitical events over the past 40-odd years, including wars and acts of terrorism, and how these three popular hedges performed during each of them. One caveat, as with any investment, is that the price of the different hedges is influenced by a variety of factors that are impossible to anticipate, so it’s unlikely the prices were influenced solely by the associated geopolitical events.

Changes to asset valuations during war and terrorist attacks

Gold is often touted as a safe haven investment when risk assets are sold off. It is interesting to note the average change in the gold price during the 12 events was a rise of only 0.7 per cent. However, with a range of negative 34 per cent to positive 27 per cent, the median change of -0.9 per cent is probably more helpful. To underscore just how unpredictable buying a hedge can be, it went up only 42 per cent of the time.

The performance of US government bonds is also surprising, given the role bonds are often perceived to play as being negatively correlated to shares. The average change was an increase in yield, meaning the price of the bonds went down. And once again, it was an even bet as to which direction the price would go.

Buying US dollars was also a pretty even bet, for a very low average return.

When you analyse the level and likelihood of returns from those three popular hedges, one message is clear: it’s really difficult to pick where markets will go and the trading costs to jump in and out could eat up a significant portion of any benefit.

Perhaps unexpectedly, the best performing asset in the table was US shares, which rose by an average of 3 per cent and the odds of a rise were much better at 75 per cent.

In another analysis of the effects of geopolitical events on the US benchmark share index, the S&P 500, LPL Research considered 22 separate events going all the way back to the Japanese attack on Pearl Harbour in July 1941.

Across a variety of wars, assassinations and terrorist attacks, the average decline in US shares was 4.6 per cent. Incredibly, the average time it took to recover all the losses was only 43 days. In other words, share markets have demonstrated tremendous resilience over many decades of turmoil.

During geopolitical events, such as Russia’s invasion of Ukraine, it can be difficult not to be swept up in the inevitable noise of expert commentators and media coverage.

It can feel like you should be doing something with your portfolio, but that’s not necessarily the case.

Hindsight bias, which makes things look obvious in retrospect, can make hedges seem like a great idea. But the data suggests a portfolio that is diversified across different regions and asset classes is a strong alternative. Smart investors should always remember that, over the long term, financial markets have a history of taking geopolitical events in their stride.