The author is president of Rockefeller International
US stocks have pulled back from the edge of the cliff — the 20 percent drop that defines a bear market. Now many are wondering how this drama ends with the worst opening of any year since 1970. I think this is the intermission, and that the next act will bring another step down.
The previous patterns suggest as much. S&P 500 records going back to 1926 show a total of 15 bear markets, with an average decline of 34 percent over 17 months. In about 75 percent of these cases — 11 out of 15 — sales halted when the market was 15 to 20 percent below the peak, reversing some losses before resuming the downward journey. This roughly sketched history suggests that what we are seeing is the intermission phase of a bear market.
Other factors are pointing in the same direction. The scale of the recent bounce, near double digits, is in line with the previous bear market halving and thus does not necessarily indicate that the decline is over.
Among the 11 bear markets interrupted by a pause, the average duration of the pause was four months. Furthermore, the US Federal Reserve is unlikely to come to the rescue of the markets this time around – with interest rates still not far below the rate of inflation.
This year’s market drop was more than the usual suspect – Fed tightening. Rather, it was the realization that this strictness predicted the end of an era. With inflation resurgent and anything but fleeting, as the easy money rush has long debated, the Fed can’t easily back down to reassure investors, as it has for more than three decades.
Fed action or inaction can determine whether a market enters bear territory. Since 1926, there have been five cases — aside from bear markets — in which stocks fell nearly 20 percent, but didn’t exceed that threshold.
In all five, market declines stopped only when the Fed intervened, loosening monetary policy. Four came in the recent era of progressively easier money – in 1990, 1998, 2011 and 2018. Now, however, a Fed rescue is highly unlikely, unless the economy goes into recession and blows the air out of inflation.
However, the downturn will spell deeper trouble for the market. And as consumer confidence and other indicators continue to worsen, the prospect of a recession is increasing.
In recent decades, amid rapid financialization in the economy and the Fed’s relentless defence, bear markets have become less frequent, but more severe and more likely to be accompanied by recessions.
11 out of 15 bear markets have also experienced recessions, including six of the last seven that date from the 1970s. Bear markets with recessions saw an average decline of 36 percent in 18 months, while 10 saw a decline of 31 percent. Months for those who weren’t.
The reason bear markets often pause for timeouts is basic: markets don’t move in straight lines, and it takes time for investors’ psychology to break through. While many institutional investors have cut stock holdings, retail investors have hardly backed down so far.
Through April, individual investors were still pouring money into US stocks and exchange-traded funds at or near a record pace, from $20bn to $30bn a month. A popular tech fund had pulled out $1.5 billion by the end of May, even though it was losing half its value. Confidence of this intensity is rare but can suddenly turn.
So far, stock valuations have declined because prices have been falling — despite flexible earnings. Despite the market slump this year, a constant drumbeat of optimistic earnings forecasts has kept the dip mindset alive. The slowdown in the economy can erode earnings and the confidence of retail investors.
Bulls have their reasons. They point to years like 1994, when the economy was so strong that the Fed’s strictly mild recession and stocks fell by a mere 10 percent. Or they sketch out ways that inflation could subside, as the pandemic and war-induced shortages in Ukraine somehow disappear, leaving the Fed to tighten up relatively soon.
For now, though, a stagnant market is hardening the resolution of the Fed, which last week began a “quantitative tightening,” a move that could set the stage for act two of this drama. Given all the risks lurking in the wings – persistent inflation, slow growth, bubbly traders – it would take a magical outcome for the next action to be more or less severe than the typical bear market of last century.