US stocks have pulled back from the edge of the cliff – the 20% drop that defines a bear market. How many people are wondering how this drama, still the worst start of any year since 1970, ends. Our view at Calvin•Farel is that this is the intermission, and that the next act will bring another step down.
Past patterns suggest as much. Records for the S&P 500 going back to 1926 show a total of 15 bear markets, with a median drop of 34% over 17 months. In nearly 75% of these cases – 11 of the 15 – selling paused noticeably when the market was down 15 to 20% from the peak, reversing some losses before resuming the trip to the bottom. This roughly sketched history suggests that what we are currently witnessing is the intermission stage of a bear market.
There are in our opinion also other factors pointing the same way. The scale of the recent bounce, near double digits, is in line with past bear market pauses and thus not necessarily a sign that the declines are over. In the 11 bear markets that were interrupted by a pause, the median length of the pause was four months.
Further, this time the US Federal Reserve (Fed) is unlikely to come to the rescue of the markets – not with interest rates still well below the rate of inflation.
What triggered this year’s market fall was more than the usual suspect – Fed tightening. Rather, it was the realization that this tightening foretells the end of an era. With inflation resurgent and anything but transitory, as the easy money crowd has long been arguing, the Fed in our opinion cannot easily back off to reassure investors, as it has for over three decades. Fed action or inaction can determine whether a market falls into bear territory. Since 1926, there have been five cases – separate from the bear markets – in which stocks fell nearly 20% but didn’t cross that threshold. In all five cases, the market stopped falling only when the Fed intervened, loosening monetary policy. Four came within the recent era of progressively easier money – in 1990, 1998, 2011 and 2018. Now, however, a Fed rescue is highly unlikely, unless the economy skids into recession and takes the wind out of inflation. A recession would, however, spell even deeper trouble for the market. And as consumer confidence and other indicators turn for the worse the chances of a downturn are in our opinion growing.
In recent decades, amid rapid financialization in the economy and constant Fed rescues, bear markets became less frequent, but more severe and more likely to be accompanied by recessions. Of the 15 bear markets, 11 have also coincided with recessions, including six of the last seven, dating to 1970. Bear markets that were accompanied by recessions saw a median decline of 36% over 18 months. Compared with 31% over 10 months for those that were not.
The reason bear markets often pause for intermission is basic: markets do not move in straight lines, and it takes time for entrenched investor psychology to break. Though many institutional investors have cut stock holdings, retail investors have barely flinched so far.
Through April, individual investors were still pouring money into US stocks and exchange traded funds (ETFs) at or near a record pace, 20 billion to 30 billion US dollar a month. One popular tech fund had drawn 1.5 billion dollar through late May, even as it was losing half its value. Faith of this intensity is in our opinion rare but can turn suddenly. So far, stock valuations have come down because prices are falling – despite resilient earnings. Even as the market dropped this year, a continuing drumbeat of optimistic earnings forecasts has kept the dip – buying mindset alive. A downturn in the economy could end this run for earnings, and retail investor confidence. Bulls based on our experience have their reasons.
They point to years like 1994, when the economy was so strong that Fed tightening triggered just a mild slowdown and a mere 10% drop in stocks. Or they sketch ways that inflation could subside, a shortages induced by the pandemic and the war in Ukraine somehow disappear, allowing the Fed to stop tightening relatively soon.
For now, however, a stabilized market is stiffening the resolve of the Fed, which began “quantitative tightening” this month, a move that in our opinion could set the stage for act two of the current drama. Given all the risks lurking in the wings – persistent 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 past century.
