Buying US equities may seem like a bad idea for some investors. The fact that sticker prices have been slashed is a reason to be concerned.

The 20 per cent decline in stocks this year is not as steep as the crashes of the past. Many are worried that the recession is only the beginning. Markets feel perilous because of that bearish consensus.

It pays to stay level-headed during times like this. Markets are along for the ride as the economy undergoes historic shocks and is likely to experience a recession. The case for buying for the recovery could be strengthened if inflationbates.

What should investors do when they're not close to the scene of the action in the US? Unhedged, the daily markets newsletter written from New York, is partnering with the Financial Times to think through the uncertainty. Unhedged has taken weeks of conversations with US market experts and boiled them down into this article.

Keep your head, start small, don't time the market, and prepare for many possibilities.

Why everyone is so bearish

The recent decline has been caused by valuation multiples falling rather than earnings being marked down. Ian Harnett ofAbsolute Strategy Research is a regular Unhedged correspondent. He pointed out in a recent piece that the drop in US stocks' 12-month trailing price-to-earnings multiple to the end of June is the biggest since 1975, when the Great Stagflation of 1975 took place.

The change in interest rates is the result of the Federal Reserve fighting inflation. The standard story says that higher interest rates make promised future earnings look less desirable than they are now.

Stock valuations are clipped in millions of analyst spreadsheets. There is selling to follow. The basic pattern of rates going up and stocks going down is the same.

Something strange has happened as rates have gone up. Steady growth for the next several years has been projected by analyst earnings forecasts.

Column chart of Earnings per share showing Consensus estimates, S&P 500: unlikely, at best

As recession calls have swept Wall Street, you would think the opposite would happen. It is believed that tighter monetary policy will make companies financing more expensive. Investment shrinks, workers get laid off and spending goes to saving, all of which slows the economy. Most companies should make less money than they thought. Analysts have recently started downgrading earnings. There could be more to come.

According to Unhedged, it is hard to argue that the market has fully priced in the possibility of a recession.

What is the reason earnings forecasts lag behind reality? 500 different company analysts' estimates are aggregated, meaning that these measures are constructed "bottom-up." When looking at the firm level, the big picture may get lost. The estimates that start by looking at the macro level data have looked less sanguine.

If the first 20 per cent drop in stocks was air leaking out of valuations, the next 20 per cent would come from earnings being marked down.

If things improve, stocks look cheap

The risk is acknowledged by even bulls. Is it possible that markets have underestimated its likelihood? One of the most vocal proponents of this view has been a member of the team at JP Morgan. He pegs the probability of a recession at 35 per cent, but says that if the US doesn't go into a recession, the stock market looks too cheap.

The average investor expects an economic disaster and if that does not materialise risky asset classes could recover most of their losses from the first half.

It's important that we understand how pessimistic markets are. The investor sentiment is worse than in the 2020 Covids because of bad economic news. You need to go back to Black Monday in 1987 to see how bad it has become. The American Association of IndividualInvestors runs a weekly survey. These are people who don't think about buying.

Line chart of Eight-week moving average showing In a bad mood: percentage share of bearish US investors

Unhedged argues that most assets are positioning for a recession. Growth stocks are more sensitive to downturns than value ones. When the economy is bad, investors are buying defensive stocks like utilities and consumer staplers. Inflation break-evens have started to fall because of a recession.

The futures markets think that the Federal Reserve will raise interest rates to stamp out inflation and thus cause a recession. Rate cuts to resuscitate the economy aren't far behind according to market pricing

It is a reasonable view but not preordained. The Fed's reaction to inflation depends on the trajectory of inflation. Sub-4 per cent inflation could prompt the Fed to be more dovish. Moderate energy prices, a lighter-touch approach to Covid in China, strong household and corporate balance sheets, and a softer Fed could keep the US economy from sliding into recession, according to the opinions of the two men.

How to play this market

The point is not that the bulls are correct. Post-pandemic markets are more uncertain. The biggest question mark of the markets is what will happen in the economy. What is the best way to invest in an individual?

Humility is a good thing. Adam Tooze wrote that if you aren't puzzled you don't get it. This isn't something you see often. It's a sign of honesty and realism to admit to being confused.

As the economic picture gets clearer, small bets can be scaled up. There are some ideas here.

There are some market segments that are worth watching. The funds are below their pre-pandemic level. Small cap stocks have lost 30 per cent of their value from their recent peak.

After adjusting for interest, tax, depreciation and amortisation, the Russell 2000 index is at its lowest multiple in a decade. Small caps are more volatile than blue-chips on the way up and down, and could be big winners in the long run.

Take the Faangs, Microsoft, lessNetflix. The S&P 500 has been ahead of them this year. Facebook and Amazon have gone down in value since November. The question is at what price. The S&P 500 has an average price/ earnings ratio of 15. The two companies are getting cheaper than they have been in the past.

While the big tech stocks are not cheap yet, they are a lot cheaper than they were, and the fact that the Zeitgeist is now anti-tech should not deter us from watching them closely as the current bear market plays out.

Don't think about timing the market. Assume that you are no more clever than the pros. The more markets fall, the more greedy you should be. Unless retirement is on the horizon, most investors want long-term exposure to the US stock market. Even if stocks are only halfway to the bottom, starting slowly to engage in dollar cost average and speeding up as prices fall can form the basis for long-term returns.

It's important to remember your allocations. If we don't have a better sense of where the economy is headed, it's wise to prepare your portfolio. Fixed-income allocations are likely to look less attractive if inflation continues. It makes sense to trim bonds to add real estate, commodities or Treasury inflation- protected securities.

Diversification can be offered by listed infrastructure projects or factor-based funds. All of these have tradeoffs. Commodities have looked poor for long-term capital appreciation while factor funds rely on having a good fund manager.

The long bull market symbolised the "buy the dip" slogan that has been ridiculed in this bear market. The American stock market usually goes up most of the time. Since 1945, the average annual growth for the US has been 8 per cent. Keeping calm and watching is better. In May, Unhedged said there would be a time to pounce.

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