Conditions Are Ripe for a Deep Bear Market

With the S&P 500 briefly on Friday down 20% from its January high, it is tempting to start trying to call an end to the sell-off. The problem is that there is only one of the conditions for a protest to be put in place, and that is that everyone is scared. That works well to pinpoint the start of the 2020 recovery, but this period may not be enough.

Other requests are that investors begin to see how the challenges are overcome and policymakers begin to help. Without those, the risk is a series of bear market rallies that don’t last, hurting dwindling buyers and further damaging investor confidence.

That confidence is inherently weak. Sentiment surveys show fund managers (surveyed by Bank of America), private investors (American Association of Individual Investors) and financial news releases (Investors Intelligence). ) was conservative in March 2020 for equities. Options that protect against a market drop have also fallen out of favor since then. And consumer sentiment, as measured by the University of Michigan, is actually worse than it was then.

In 2020, that should be more than enough, because central bankers and politicians alike are scared. When they got into it, it helped investors see that, with government support, companies could make it through.

This time, central banks are scared not by falling markets or the economic outlook, but by inflation. Sure, if something big happens in the financial system, they will focus on finance and the recession might make them rethink rate hikes. But for now, inflation means falling stock prices are seen only as a side effect of tighter monetary policy, not as a reason to call on the “Fed to take” and bail out investors. .

There’s nothing magical about a 20% drop, the usual definition of a bear market. But it adds up a lot: Over the past 40 years, the S&P 500 has bottomed out with a 20% drop or peak-to-trough four times, in 1990, 1998, 2011 and 2018. Four more times. suffered much greater damage, as the panic actually took hold.

The common factor in the 20% drop was the Federal Reserve. Each time, the market bottoms out as the central bank eases monetary policy, with the stock market slump perhaps pushing the Fed to consider more serious threats that could follow. out.

My concern is that this moment might look like 1973-1974. As at the time, the country’s primary concern was inflation, caused by the war-related oil price shock. Just like then, the inflation shock continued as the Fed made interest rates too low given the size of the political stimulus to the economy. Just like then, popular stocks — Nifty Fifty, now FANGS and related acronyms — have skyrocketed in previous years.

Most importantly, in 1974, the Fed continued to raise interest rates even during a recession because it was running to catch up with inflation. The result was a terrible bear market interspersed with soul-destroying temporary rallies, two out of 10%, two at 8% and two at 7%, each of which was scrapped. It took 20 months before the trough was reached — no coincidence, when the Fed finally started getting serious about cutting rates.

The timing hasn’t been bad for stocks so far, especially since the economy isn’t in a recession. If inflation falls, the Fed won’t need to raise rates as much as indicated, which would be a big boon for the hardest-hit stocks.

I remain hopeful that the economy will prove resilient, although it will be a long time before we know enough to make it a good bet. To put it really simply, however, after the stock doubled in two years, the market fell than more than 20% seems perfectly reasonable.

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Write to James Mackintosh at james.mackintosh@wsj.com

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Edmund DeMarche

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