The writer is president of Rockefeller International
US stocks pulled back from the edge of the cliff – the 20% drop that defines a bear market. Now many people are wondering how this drama, which remains the worst start to a year since 1970, ends. My view is that this is the intermission, and the next act will bring another step down.
Past models suggest so. S&P 500 records dating back to 1926 show a total of 15 bear markets, with a median decline of 34% over 17 months. In almost 75% of those cases – 11 out of 15 – the selling was noticeably halted when the market was down 15-20% from the top, undoing some losses before resuming the downward journey. This roughly sketched story suggests that what we are witnessing is the intermission stage of a bear market.
Other factors point in the same direction. The magnitude of the recent rebound, near double digits, is consistent with past bear market breaks and therefore is not necessarily a sign that the declines are over.
In the 11 bear markets that were interrupted by a pause, the median duration of the pause was four months. Moreover, this time the US Federal Reserve is unlikely to come to the rescue of the markets – not with interest rates still well below the rate of inflation.
What triggered the market slide this year was more than the usual suspect – Fed tightening. It was rather the realization that this tightening predicts the end of an era. With inflation on the rise and anything but transitory, as the easy money crowd has long claimed, the Fed cannot easily back down to reassure investors, as it has for more than three decades.
The action or inaction of the Fed can determine whether a market falls into bearish territory. Since 1926, there have been five instances – distinct from bear markets – in which stocks fell nearly 20% but did not break through that threshold.
In the five, the market only stopped falling when the Fed stepped in, easing monetary policy. Four have entered the recent era of progressively easier money – in 1990, 1998, 2011 and 2018. Now, however, a Fed bailout is highly unlikely unless the economy slides into recession and does blow on inflation.
A recession, however, would cause even more serious problems for the market. And as consumer confidence and other indicators deteriorate, the odds of a slowdown increase.
In recent decades, amid the rapid financialization of the economy and constant bailouts from the Fed, bear markets have become less frequent, but more severe and more likely to be accompanied by recessions.
Of the 15 bear markets, 11 also coincided with recessions, including six of the last seven dating back to 1970. Bear markets with recessions saw a median decline of 36% over 18 months, compared to 31% over 10 months. months for those who were not.
The reason bear markets often pause is fundamental: markets don’t move in a straight line and it takes time for ingrained investor psychology to break. Although many institutional investors have reduced their equity holdings, retail investors have been largely unfazed so far.
Until April, individual investors were still pouring money into US stocks and exchange-traded funds at or near record rates of $20 billion to $30 billion a month. A popular technology fund had attracted $1.5 billion through the end of May, even as it lost half its value. Faith of this intensity is rare but can turn sharply.
So far, stock market valuations have fallen because prices are falling, despite resilient earnings. Even though the market has fallen this year, a continued drumbeat of optimistic earnings forecasts has kept the buying mood down. A slowdown in the economy could put an end to this race for profits and the confidence of retail investors.
Bulls have their reasons. They point to years like 1994, when the economy was so strong that Fed tightening only triggered a mild slowdown and a barely 10% drop in stocks. Or they sketch ways in which inflation could ease, as the pandemic- and war-induced shortages in Ukraine somehow fade away, allowing the Fed to stop tightening enough. rapidly.
For now, however, a stabilized market bolsters the resolve of the Fed, which began “quantitative tightening” last week, a move that could set the stage for the second act of this drama. Given all the risks lurking behind the scenes – lingering inflation, slower growth, bubbly traders – it would take a magical outcome for the next act to be shorter or less severe than the typical bear market of the last century.