Bottom or Bear?

by Justin Lowry, President & CIO, Global Beta Advisors, LLC

On April 22, the S&P 500 Index had officially crossed into correction territory for the fourth time this year from its latest high of 4796.56, made on January 3. Prior to this year, the S&P 500 had a nearly 2-year period without a market correction. The last correction prior to this year was on June 26, 2020.

S&P 500 Returns from All Time Highs

SP. Returns from All Time

Source: Data from FactSet measuring returns from the most recent all time high of the S&P 500 at that time from 01/31/71 through 04/30/22. Orange line denotes “correction” territory. Red line denotes “bear market” territory.


The above chart illustrates the daily returns of the S&P 500 versus the index’s most recent all-time highs at each point over the past 50+ years (“Source: data from FactSet measuring returns from the most recent all time high of the S&P 500 at that time from 01/31/71 through 04/30/22.”).  You’ll notice seven instances where the S&P 500 devolved from correction to bear market – the inflation crisis throughout most of the 1970s, the recession during the early 1980s, the 1987 “black Monday” market crash, the tech crash in the early 2000s, the 2008 financial crisis, the 2011 U.S. credit downgrade/European contagion scare and the 2020 COVID-19 health pandemic.  You’ll notice in the summer of 2010 that the S&P 500 dipped back into bear market territory after briefly coming out of it from the financial crisis.  However, in our determination, it was a continuation of the 2008 Financial Crisis bear market.

There were five instances where the S&P 500 moved into correction territory but was able to avoid a bear market – the summer of 1984, the early 1990s, October 1998, the end of 2015 into the beginning of 2016, and December 2018.

The question we pose is:  which path will this dip into correction follow – a bear market or a bounce from the bottom?  To help answer that, we need to explore commonalities between each and all these instances.

Of course, the bear markets were largely preceded or were the result of historic economic recessions, although the catalyst for each was slightly different.  Each bear market was approximately 10 years apart, which would make a bear market in 2022 the shortest span between bear markets over the past 50 years.

US GDP Growth

US GDP Growth

Source: data from FactSet measuring year-over-year Gross Domestic Product (“GDP”) growth from 03/31/71 through 03/31/22. Red circles donates recessionary periods.


The Bear Markets

The recessionary periods throughout the 1970s and the early 1980s were largely driven by fundamental fiscal issues coming out of World War II and the Vietnam War.  Compounding that issue was the Iranian civil war, which constrained global oil supply.  These issues significantly contributed to inflationary issues, which dampened the economy.

The recession during the early part of the 1990s was more of a technical recession, which was a byproduct of the Federal Reserve combating lingering effects from inflationary pressures during the 1970s and 1980s.

The tech crash and the Financial Crisis were systematic market breakdowns.  The tech crash was the result of companies with poor business models that were funded with substantial private equity money on the prospect of growth in technology.  However, in our opinion, secular growth in a particular industry cannot compensate for a bad business model.  As liquidity began to tighten, these businesses began to fail, resulting in a derailing of the overall economy.  The Financial Crisis was built on the back of loose standards for debt issuance.  Further exasperating the issue was the fact that financial markets combined subprime debt with prime debt into pooled debt instruments, blinding investors to the inherent risk of the overall investment.  This then tied institutional money to the risks underwritten by the banks.

The COVID-19 global health pandemic was an unforeseen “black swan” event.  The pandemic led to an artificial shutdown of the global economy, leading to a global recession.  However, even in the wake of the initial onslaught of the pandemic was the residual fear of continued variations of the virus, which led to a slowing and restarting of consumer demand.  This has also weighed on the supply chain as rolling shutdowns have curbed production.

To summarize, the bear markets and recessions illustrated early on were driven more by fiscal and monetary policy issues, however, the most recent bear markets and recessions were driven by market behavior and a global health pandemic, respectively.  At this point, it appears that a potential bear market is being telegraphed in a similar fashion as it was during the 1970s and 1980s, where markets that fell into correction territory were saved from a bear market thanks to an accommodative Federal Reserve.  Below, you will see the spread between year-over-year inflation and the federal funds rate:

Inflation vs Fed Funds Rate Spread

Inflation vs Fed Funds Rate Spread

Source: data from FactSet measuring the spread between year-over-year consumer price index growth versus the Federal Funds Rate target from 01/31/71 through 04/30/22.


As you can see, we are currently witnessing the largest spread between monetary policy and inflation in the past 50 years.  This relationship is like what we observed in the 1970s and the 1980s, whereby, inflation outpaced the actions of the Federal Reserve.  However, the difference this time around is that the Federal Reserve will be raising rates from a far lower level.  This can be good and bad.  On the one hand, it should be easier to combat sustainable inflation this time around, given how marginal rates would reach relative to historical norms.  On the other hand, market valuations have bubbled so substantially due to unprecedented accommodative monetary policy that even a move from 25 basis points to 75 basis points, for example, will likely cause significant disruption to the market, particularly among companies with the richest valuations.

The Corrections

The correction that occurred during the summer of 1984 was a more typical mid bull market pull back.  As the market was making new highs coming out of the recession during the earlier part of the decade, major indexes were testing new lows.  From July 1984 through December 1984, the Federal Reserve cut rates by nearly 300 basis points, which ultimately prevented the market from sinking into bear market territory.

In the early 1990s, the economy encountered a brief and moderate recession driven by the Persian Gulf war’s impact on oil prices globally and the resulting actions being taken by the Federal Reserve to combat inflation.  However, from October 1990 through September 1992, the Federal Reserve cut rates by 500 basis points, and thus, the market never crossed into bear market territory.

In October 1998, investors began to fear that the technology surge was beginning to unravel with large private equity and hedge funds filing for bankruptcy.  The Federal Reserve ended up cutting interest rates by 50 basis points between October and November of 1998, which enabled more liquidity and ultimately preserved the bull market.

Between August 2015 and February 2016, the S&P 500 crossed into correction territory for a multitude of factors:  the Federal Reserve was beginning to raise interest rates for the first time since the 2008 Financial Crisis, bubbling fears of contagion from the “Brexit” negotiations, concerns about emerging market countries de-valuing their currencies relative to the U.S. dollar, and the fact that 2016 was an election year.  As currency wars began to abate and the Federal Reserve raised at a far more modest pace than expected, the S&P 500 never tested bear market territory.  This is the only market correction that was not saved by the Federal Reserve cutting interest rates, largely because they did not have the room to make substantial rate cuts.  However, notably, the Federal Reserve did reduce the magnitude to which they planned on raising rates.

Lastly, the markets encountered a near bear market in December 2018 when the Federal Reserve began to signal further monetary policy tightening amidst growing geopolitical tensions between the U.S. and China as well as weaker earnings outlooks.  After raising rates by 100 basis points throughout the calendar year, the market began pricing in a 50% chance of another 25 basis point rate hike in December 2018, based on the Federal Funds futures activity.  Not only did the Federal Reserve halt plans to raise rates further, they ended up cutting rates by 75 basis points throughout the course of 2019.  This abrupt, 180-degree policy shift likely saved the S&P 500 from a sustained bear market.

Fed to the Rescue

Fed to the Rescue

Source: data from FactSet of Federal Reserve Federal Funds Target Rate from 01/31/71 through 04/30/22. Red circles denote periods where the S&P 500 fell into correction.


As you can see, the Federal Reserve responded to each of these corrections with swift actions to loosen monetary policy except for the late 2015/early 2016 period.

How Today’s Market Fits In

As posed earlier – where is the current market heading?  Are we bottoming out or heading into a bear market?  Our concern, as illustrated in the above inflation versus fed fund rates spread chart, is that the Federal Reserve has gotten so far behind the curve in managing inflation that it appears to mirror issues encountered during the 1970s.  While rates and the Fed’s actions are in a similar situation as it was in late 2015/early 2016, inflation was not nearly at levels then as it is now.  We also believe the rolling COVID shutdowns in China are causing a major strain on the supply chain, therefore, curbing demand likely only solves part of the issue.  We believe that, regardless of whether the Federal Reserve ultimately slows the rate at which they raise rates, market volatility will continue to persist.  Below is an outline of how different market factors respond in different macro environments:

Market Factors in Different Economic Environments

Market Factors

Source: returns measured in each instance from 12/31/1996 through 03/31/22. “Volatility” measures the returns of the S&P 500 Low Volatility Index, “Growth” measures the returns of the S&P 500 Growth Index, “Value” measures the returns of the S&P 500 Value Index, “Quality” measures the returns of the S&P 500 Quality Index, “Momentum” measures the returns of the S&P 500 Momentum Index, and “Size” measures the returns of the S&P 600 Index.


As you can see, if we do enter a rising rate environment, that appears to be more positive for size, yield, and quality factors.  However, if we do fall into recession, we believe that the Federal Reserve would then have to back track its tightening strategy, which would enable a better environment for growth.  In our opinion, it is very unlikely we encounter a recession, given how recent the last recession was.  As shown above, the average duration between recessions is about 7-10 years.  Based on the above research, history would suggest that a recession is unlikely over the next 12-18 months.  Of course, circumstances now do not entirely mirror the past, but there are clear similarities.  Regardless, we believe that investors need to prepare for continued volatility as the market continues to try to handicap the Federal Reserve’s decision making on monetary policy and how it may impact overall earnings growth.  In our opinion, finding securities or strategies that curb drawdown effects that offer average to above average yield is prudent during these market conditions.

Definitions

Market Correction – any major index that is -10% from a recent high.

Bear market – any major index that is -20% from a recent high.

Gross Domestic Product (“GDP”) – the measurement of the production of goods and services.

Black Swan Event – an unforeseen event that bears negative consequence to the markets.

“Brexit” – nickname provided to the ongoing negotiations between the United Kingdom and the European Union to solve for the United Kingdom’s liberation from the European Union.

Basis points – signifies 1/100 of 1 percentage point.

S&P 500– a stock market index that tracks 500 of the largest companies listed on U.S.

 

Opinions expressed are subject to change at any time, are not guaranteed and should not be considered investment advice.

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