SPY: 4 Reasons This Bear Market Could Be Worse Than 2008 & 2020 (SPY)

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After hitting new all-time highs in early January, the S&P 500 (NYSEARCH:SPY) has tumbled to the point where it is now flirting with bear market territory. In fact, earlier this month it officially breached the 20% off the highs metric used to officially label a bear market:

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Data by YCharts

This decline has been led by sharp pullbacks in many big tech giants like Tesla (TSLA), Amazon (AMZN), Netflix (NFLX), Meta (FB), and even Apple (AAPL):

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While it can be argued that the market has corrected itself enough as each of these tech titans have strong cash flow generation and continue to post strong performance metrics with competitive advantages and stellar balance sheets, we think things too they could get much worse before they happen. to improve. In this article we will discuss four reasons why this might be the case.

Reason #1: Much lower interest rates

One of the biggest ways the Federal Reserve has fought bear markets was by cutting federal funds rates. This method has proven to be very effective because, as Warren Buffett likes to say,

Interest rates are like gravity in valuations. If the interest rates are nothing, the values ​​can be almost infinite. If interest rates are extremely high, that’s a huge gravitational pull on securities… The most important element over time in the valuation is obviously interest rates. Low interest rates make any investment earnings stream worth more money. Any investment is worth all the money you’re going to take out between now and Judgment Day, discounted. Well, the subsequent discount is affected by the interest rates you use.

The fed funds rate has a particular impact on the securities market because it is the interest rate that depository institutions charge each other for overnight loans and is also the primary basis for determining the prime rate, which in turn influences mortgage loan rates, credit card rates, and many other consumer and business loan rates. As a result, every time the Federal Reserve raises the fed funds rate, it raises the cost of money and therefore reduces its supply. Lowering the fed funds rate has the opposite effect, increasing the money supply by lowering its cost.

This has a double impact on the stock market. In addition to impacting the discount rate used to determine stock valuations, it also impacts economic activity. Higher interest rates generally reduce consumer demand and increase business debt servicing costs, while lower interest rates generally increase consumer demand and reduce business debt servicing costs, encouraging them to to ask for more loans to invest in expansion projects.

With this in mind, it’s informative to note that in both the run-up to the 2008 crash and the 2020 crash, interest rates were significantly higher than they are today:

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What this means is that previous booms were held at much higher interest rates than the current boom and that therefore the Federal Reserve had much more economic “ammunition” to fight those downturns by reviving the economy through of dramatic increases in interest rates. By contrast, the current environment offers the Federal Reserve only very little room to stimulate the economy. In fact, the Federal Reserve is talking about raising interest rates significantly more, so the chance of an interest-rate-related stimulus to get through the current recession is very low at this point. This means that the current downturn in SPY could end up being much worse and potentially much longer than the last two.

Reason #2: Much Higher Inflation Rates

In addition to the headwind related to interest rates, inflation also poses a huge threat to the current economic situation which could also lead to this recession being much worse and longer than the previous two.

Similar to interest rates, high inflation has a double whammy on the stock market, as it often means companies’ profits are reduced due to reduced consumer demand and reduced income. profit margins, while pushing investors to seek high nominal total return potential on investments in order to generate real (ie net of inflation) returns.

In addition, it also has a very negative impact on the Federal Reserve’s ability to combat an economic and/or stock market downturn by lowering interest rates and printing money, as these measures further exacerbate inflation. In fact, the Federal Reserve is working to reduce the size of its balance sheet rather than expand it further, which means it is unlikely to expand quantitative easing to revive the economy in the current environment. This means that the Fed’s hands are largely tied here, preventing it from doing much to combat the current recession in contrast to the previous two recessions when the government engaged in massive quantitative easing:

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Reason #3: Greater geopolitical obstacles

It is no secret that the geopolitical headwinds are greater today than they were in 2008. In addition to the war in Ukraine, the threat of war in East Asia, the Middle East, and the possibility of expanding into a global war or even a nuclear war is perhaps greater. than it has ever been since the end of the Cold War. Palantir (PLTR) CEO Alex Karp said the other day on CNBC that the chance of nuclear war is 20-30%, while Ray Dalio has repeatedly emphasized that we are transitioning to a new world order where conflict between the established great power (the United States) and the rising great power (communist China) is increasingly likely.

Meanwhile, we are still dealing with stubbornly persistent COVID-19 outbreaks in strategic locations like Shanghai, China, and the world appears to be headed for food shortages due to fallout from the Ukraine war and persistent supply chain issues.

While the 2020 crash was driven entirely by fears and uncertainty over the COVID-19 outbreak (which turned out to be largely unfounded aside from the negative impacts of government lockdown measures), the headwinds Long-term current geopolitical headwinds are potentially much more severe. In particular, there is the fact that rising geopolitical tensions undoubtedly mean reduced world trade and much higher government spending (i.e. taxes and inflation), imposing serious long-term burdens on the world’s leading economies. world.

Reason #4: Much higher ratings

Last but not least, the valuations we are seeing today are much higher than they were in the run up to the 2008 and 2020 crises.

At its pre-crash peak in 2007, the S&P 500 traded at a P/E of less than 19.42x.

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At its pre-crash high in 2020, the S&P 500 traded at a P/E of 23.16x.

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At its peak before the recent pullback, the S&P was trading at a P/E of 24.09x.

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Additionally, the Buffett indicator, a metric that compares the value of the US market to its GDP, was well over 200% in his recent package, up from around 175% in early 2020 and barely over 150%. Drop peak prior to 2008.

Investor Takeaway

SPY has had a tremendous run, combining low fees (currently the expense ratio is just 0.09%) with high liquidity to amass at its peak more than $450 billion in assets under management.

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Index investing has become wildly popular with retail investors and SPY has given them little reason to look elsewhere, roughly tripling investors’ money over the past decade and offering the most passive and liquid highly diversified investment vehicle on the planet. .

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However, with interest rates hovering near record lows and most likely rising in the near term, inflation rates at four-decade highs, geopolitical headwinds at multi-decade highs, and market valuations near record highs, investors indexed in SPY could be in a difficult situation. rude awakening.

As a result, we are working diligently to build a portfolio of high-quality dividend stocks, many of which have a low correlation to SPY, to prepare for potential outperformance in what could be some very difficult years for the S&P. 500.

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