Key takeaways:
- Historically, you get a drawdown every two years and a big drawdown every nine years. And the market event is often detached from the economic event
- Three things make a drawdown more likely: a lack of volatility, inflation that is too high or too low, and expensive valuations. We examine each in turn
- There seems no disputing that we are high up. But, as ever, there remains the question of whether this market is at the peak, or in the euphoric final phase
Of late, other Man Group comrades and I have been doing a lot of thinking about the nature of equity market drawdowns.1 But is this wasted effort? By the time that research becomes useful, you may be flogging a stable door, far from the bolting horse. That’s perhaps overstating it, but it has prompted me to dedicate similar attention to the period of time just before the drawdown. Herewith my reflections so far.
As ever with this kind of analysis, there is the question of what counts as a drawdown. What negative percent is an event rather than just noise? Do you look for the all-time or the local peak? You can drive yourself insane wrestling with such questions. In Figure 1, I’ve combined a defined set from Morgan Stanley, together with our own analysis and the all-seeing AI, to come up with 59 drawdown episodes over the last 100 years. I have divided these into four categories based on severity, and overlaid them on the S&P, plotted on a log scale.
Figure 1. Drawdown incidence: this is your pain schedule
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Source: Man Group defined drawdowns, compared against a similar list from Morgan Stanley, Bloomberg. As of December 2025.
I won’t go too far into the detail, as the point of this paper is the peaks not the troughs but, while we’re here, allow me a few words:
- Drawdowns are felt daily, and perhaps even intraday. Defining with less granularity is, ultimately, a form of hindsight bias
- Numbers matter. The base rule in the above is that a drawdown is 10% or greater. What’s special about 10%, other than being round and vaguely big sounding? It is a reasonable question, but it overlooks a key point: investors develop behavioural attachments to numerical thresholds. When these levels are breached, the commentariat amplifies the signal
- A big rally within a drawdown – a bear market rally, in the jargon – very likely resets the psychology of those living through it. In other words, sell-offs close to one another, but with an intervening surge, should be seen as separate events)
One takeaway from Figure 1 is a base rate for summit frequency. History suggests we can expect a peak every two years and a major peak every nine years. But other than time, are there any other patterns which speak to the position of peaks?
Economic data offers one potential source. However, if we were to overlay this chart with National Bureau of Economic Research (NBER) recessions, the overlap would likely be less than you might expect. Or at least than I had expected. The bar plot below shows summary statistics for the relation between drawdowns and recessions.
Figure 2. Recession and drawdowns are different things
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Source: NBER, Man Group. As of December 2025.
Getting on for half of all drawdowns do not occur in the context of an economic downturn, before or after. Even in the most severe cases, recession incidence is surprisingly low: of the 11 30%+ drawdowns, more than a quarter (three) are recession-less. Moreover, for 15%+ sell-offs, more often than not, the economic pain follows the market pain, and not the other way around. The tone of much financial research is economic fundamentals first, price action second. You could do worse than to turn that process on its head.
This is evidenced in the three major drawdowns which had nothing to do with a recession, as already alluded to. These began in October 1939 (through to April 1942, the market falling 43% in this time), November 1968 (to May 1970, -36%) and August 1987 (through to December 1987, -34%). Respectively driven by the start of World War Two, the Nifty Fifty bubble burst and Black Monday. These three events – a global war, a valuation implosion and programmatic trading heart attack – clearly affect stock markets but leave the economy unmolested, at least in the near term. Major conflicts, for instance, almost certainly cause economic (as well as other) damage eventually, but on a near horizon, output likely increases as the nation is switched to mandatory high-capacity utilisation war setting.
It is not possible to predict drawdowns. But our research shows there are three things which make a drawdown more likely. The first is a lack of volatility. The devil makes work for idle thumbs, so they say, and most will be able to find evidence for this in their own lives. What is true personally also applies to financial markets. Stability is the midwife of instability, the so-called Minsky Moment. This makes sense qualitatively: there’s nothing like extended calm seas to deaden an investor’s attentiveness. It can be evidenced empirically, as in Figure 3, which shows volatility in the 12 months leading up to each of our 59 peaks, relative to the unconditioned 12 months.
S&P trailing risk today is 15.5%, or a little under 300 basis points (bps) below the unconditional. We believe we are in the danger zone. Not egregiously so, but there nonetheless.
Figure 3. This is what a Minsky moment looks like
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Source: Bloomberg, Man Group. As of December 2025.
Secondly, inflation. I have often pointed to this as a key – and perhaps the key – determinant of a successful asset allocation process. Central bankers, as a reminder, aim to keep inflation like the smallest bear’s porridge. Stocks don’t like price rises that are too hot because, although revenues might be nominal, so are the cost of goods sold (COGS) – the money illusion is not as strong as economists think, in other words. Stocks don’t like price rises that are too cold (i.e. deflation) because of the negative implications it has for the credit impulse, and therefore on real economic growth.
Figure 4 shows the percentage change in the Consumer Price Index (CPI), again in the 12-month build-up to each peak. Overlaid are lines indicating a 1% level of inflation (below which the market is concerned by deflation) and 2.5% (above which it is concerned with overheating). In 73% of episodes, we are outside of this comfort zone at the peak.
If we were at the market peak now, we would be within this precedent, with US CPI at +2.7% year on year.
Figure 4. Going into a drawdown, inflation is usually too high or too low
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Source: BLS, Man Group. As of December 2025.
Finally, valuation. One of the first lessons of investment is that cheap/expensive alone is never enough for buy/sell. Indeed, as a signal for market timing, its track record is remarkably poor. But it is also true that, in a large majority of our peak episodes, multiples are high relative to recent history. As Figure 5 shows, in almost three quarters of instances, the multiple on the eve of the drawdown is above the trailing three-year average, and by a mean margin of 1.6 points.
This is intuitive given that the behaviour of earnings into the peak is mixed, so by process of elimination we know that multiples must be doing some heavy lifting. It is also the case that, while high valuations don’t tell you a drawdown is imminent, they do tell you something about drawdown potential. If other catalysts come together, a higher multiple provides more kindling for the blaze.
The Shiller price-to-earnings (PE) ratio today is 39x, a full six points above the trailing three-year average. Our other two ‘peak heuristics’ put us in the danger zone, but on its edge. This one puts us squarely in the middle.
Figure 5. Going into a drawdown, valuations have typically been expensive
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Source: Shiller CAPE data, Man Group. As of December 2025.
One metric that is often talked about when people discuss their stock market anxiety, or lack thereof, is earnings growth. Our final chart therefore shows the scale of real earnings growth for US stocks, over the same periods we have been looking at in the other exhibits. And there’s not much pattern. If anything, earnings are more likely to be growing than not going into the peak. 59% of the time real earnings growth is positive, and in more than a third of episodes it is above 10%.
Figure 6. Earnings don’t tell you much about drawdowns
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Source: Shiller earnings data, Man Group. As of December 2025.
There seems no disputing that we are high up. But as Charles Mackay wrote in his classic Extraordinary Popular Delusions and the Madness of Crowds:
“He [John Law] did not calculate upon the avaricious frenzy of a whole nation; he did not see that confidence, like mistrust, could be increased almost ad infinitum, and that hope was as extravagant as fear.”
So, as seems very likely to me, we may well be looking down from the 80th floor. But we don’t know whether the building we’re in is the Shard (and we’re at the top) or the Burj Khalifa (and we’re only halfway there). Investors should be under no illusions, however. At such great heights, falling from either window will kill you.
1. See, for instance: https://www.man.com/insights/road-ahead-preparing-for-equity-drawdowns
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