Conditions are ripe for a deep bear market

With the S&P 500 briefly down 20% from its January high on Friday, it is very tempting to start trying to call the end of the sell-off. The problem is that there is only one of the conditions for a rally, that everyone is afraid. That worked great to time the start of the 2020 rebound, but this time it may not be enough.

The other requirements are that investors begin to see a way to overcome the challenges and that policymakers begin to help. Without them, the risk is a series of bear market rallies that don’t last, hurting buyers and further damaging investor confidence.

That trust is already weak. Sentiment surveys show that fund managers (surveyed by Bank of America), private investors (the American Association of Individual Investors), and financial newsletters (Investors Intelligence) are already at March 2020 levels of caution about Actions. Options that protect against market declines have also not been as popular since then. And consumer confidence, as measured by the University of Michigan, is actually worse than it was then.

In 2020 that was enough, because the central bankers and politicians were scared too. When they intervened, it helped investors see that, with government support, companies could get by.

This time around, central bankers aren’t scared by falling markets or the economic outlook, but by inflation. Sure, if something big breaks in the financial system, they’ll refocus on finance, and a recession can lead them to reconsider rate hikes. But for now, inflation means falling stock prices are seen simply as a side effect of tighter monetary policy, not a reason to invoke the “Fed put” and bail out investors.

There is nothing magical about a 20% drop, the usual definition of a bear market. But a lot comes up: Over the past 40 years, the S&P 500 has bottomed out with a 20% peak-to-trough decline about four times, in 1990, 1998, 2011 and 2018. Another four times it had much bigger losses, as the true panic took hold.

The common factor in the 20% declines was the Federal Reserve. Each time, the market bottomed out as the central bank eased monetary policy, and the stock market decline perhaps helped push the Fed to take the threats more seriously than it might otherwise.

My concern is that this time it might be more like 1973-1974. As then, the country’s main concern is inflation, thanks to a war-related oil price shock. As then, the inflationary shock took hold when the Fed had rates too low given the scale of the political stimulus for the economy. Like then, favored stocks (the Nifty Fifty, now the FANGS and associated acronyms) had soared in previous years.

Most importantly, in 1974 the Federal Reserve kept raising rates even as a recession hit because it was racing to catch up with inflation. The result was a horrible bear market interspersed with soul-destroying temporary rallies, two 10%, two 8%, and two 7%, each off. It was 20 months before the bottom was reached, not coincidentally, when the Fed finally started getting serious about cutting rates.

So far, this time hasn’t been too bad for stocks, especially since the economy isn’t in a recession. If inflation subsides, the Fed won’t need to raise rates as much as it has indicated, which would be a boon to stocks that have suffered the most.

I am still hopeful that the economy will prove resilient, although it will be a long time before we know enough to make it a good bet. However, in really simple terms, after the stock more than doubled in two years, a market crash of plus 20% seems entirely plausible.

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

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It appeared in the May 23, 2022 print edition as “Conditions are ripe for a deep bear market.”

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