Technically, we are right on the cusp. By definition, a ‘bear market’ in stocks occurs at the point of a -20% price drop from a recent peak—we’re within a percent or two from that threshold.
Although this recent movement seems sudden and severe, and is, relative to the last few years of unusually low volatility, deeper corrections of at least -15% have occurred about once every two years, with -20% bear markets appearing once every 3-4 years, historically. Based on statistics, we’ve been overdue. The unique part is that such downturns usually happen over the course of 10-15 months, as opposed to the rapidity of this decline, measured from the peak in the S&P on Sept. 21.
What is going on?
The panic is not based on any new information. Many investors look for a simple explanation when stocks move through a stretch of negatively. Often, it’s not a single reason, but a collection of various fears and uncertainties, that simply cause investors to begin shedding ‘risk assets’ in a sell-first-ask-questions-later approach. This has also affected other assets related to global demand, such as crude oil.
Bear markets have often surfaced prior to upcoming recessions, due to fears about how severe an economic downturn would be, they don’t appear as frequently in isolation (although there are exceptions, which have occurred about three times in the last thirty years, the worst of which being in 1987 and 1998). This appears to be the primary reason in this case—the risk of recession appears to have increased due to slowing in some aspects of the economy. In addition, the lack of dovish tone by the Federal Reserve in recent weeks (including the FOMC statement last week, which was not supportive enough for markets) raised fears that the quarterly rate hike pace could be too much for the economy to handle. In fact, the Fed raising rates too far and too fast has been a catalyst for recessions in the past, so this fear is not unfounded.
Along the lines of these fears of economic slowing, the ongoing U.S-China trade tensions have remained in the market consciousness, with no resolution in sight. Although the estimated effects of new tariffs won’t appear to have a catastrophic effect on GDP, they certainty don’t help matters, and could dampen sentiment that may ultimately affect global economic growth. Adding a unique holiday trading environment of lower liquidity and staffing can also exacerbate declines.
Last week, these items were coupled with fears over a politically-driven government shutdown, which drove market sentiment from bad to worse. The President was also apparently consulting with advisers about the possibility of and process for firing Fed Chair Powell due to unhappiness over the path of interest rate hikes. (Obviously, this threatens the long-standing independent and apolitical nature of the Fed, harkening back to political pressure placed on it during the late 1960’s, thought to be a partial cause of the nasty inflation of the 1970’s.) If this weren’t enough, Defense Secretary Mattis resigned, which raised more questions about the future composition of the Cabinet, and willingness of members to stay on. While not major news from a financial standpoint, each of these items add to lack of certainty about future policy direction.
Now that markets have assumed the worst—seemingly pricing in an imminent recession—what’s the upside?
Firstly, and importantly, deep corrections and bear markets bring valuations down. This may seem obvious, but removing froth from asset valuations following a bull market run can ‘refresh’ the attractiveness of stocks. While always a moving target, and not as meaningful for the short-term, returns over the long-term have been lower from more expensive starting points, higher from cheaper starting points, and ‘about average’ when assuming ‘average’ starting valuations. Per FactSet, the 12-month forward P/E for the S&P as of Friday was 14.2x (long-term averages tend to be 15-16x).
Another positive aspect is that earnings growth remains positive. This is another straightforward observation, but recessionary fears have tended to rise when either GDP or earnings growth has been at the crux of flattening or declining outright. This year was extraordinary, with earnings growth exceeding 20% based on the impact of prior year tax cuts, which is the highest level since 2010. While this effect is expected to temper in 2019, it is not falling off a cliff completely, with FactSet projecting earnings growth of 8%. Using back-of-the-envelope expected return calculations of dividend yield plus earnings growth plus/minus valuation adjustments, forward-looking metrics don’t look far off from historical averages.
Interestingly, in the midst of all of the current negative market sentiment, the outlook and commentary on equities from a variety of sources is more constructive than it has been in some time, due to lowered valuations, continued positive earnings growth and lack of immediate recession red flags on the horizon, such as in credit markets. Assuming the U.S. avoids a recession in the next few quarters, it is possible that a bear market could be shorter-lived. However, with the economy showing more signs of later cycle behavior, the risk of these types of market events (both due to poor investor sentiment and those backed up by deteriorating fundamentals) goes up.