Stocks crashing? No, but here’s why this bear market is so painful – and what you can do about it.

By William Watts

Stock market crash hashtags may be all the rage on Twitter, but the selloff that sent U.S. stocks into a bear market was relatively orderly, market professionals say. But it’s likely to become more volatile – and painful – before the market stabilizes.

What is happening?

It was indeed a tour de force for investors on Friday as the Dow Jones Industrial Average plunged more than 800 points and the S&P 500 index traded below its 2022 closing low from mid-June before cutting losses before the bell. The Dow fell to its lowest close since November 2020, leaving it on course to join the S&P 500 in a bear market.

Why is the stock market falling?

Rising interest rates are the main culprit. The Federal Reserve is raising its benchmark interest rate in historically large increments — and plans to keep raising them — as it attempts to bring inflation back to its 2% target. As a result, Treasury yields soared. This means that investors can earn more than before by collateralizing money in public securities, which increases the opportunity cost of investing in riskier assets like stocks, corporate bonds, commodities or real estate.

Historically low interest rates and abundant liquidity provided by the Fed and other central banks in the wake of the 2008 financial crisis and the 2020 pandemic have helped drive demand for riskier assets such as shares.

That outcome is part of why the sell-off, which is not limited to stocks, looks so tough, said Michael Arone, chief investment strategist for the SPDR business at State Street Global Advisors.

“They struggled with the idea that stocks are down, bonds are down, real estate is starting to suffer. From my perspective, it’s the fact that interest rates are rising so quickly, that which leads to declines at all levels and volatility at all levels,” he said in a telephone interview.

How bad is that?

The S&P 500 index ended Friday down 23% from its record close of 4,796.56 reached on January 3 this year.

It’s a significant step back, but it’s not out of the ordinary. In fact, it’s not even as bad as the typical bear market retreat. Wells Fargo analysts studied 11 past S&P 500 bear markets since World War II and found that bear markets lasted an average of 16 months and produced a negative return of 35.1% in the bear market.

A decline of 20% or more (a widely used definition of a bear market) has occurred in 9 of the 42 years dating back to 1980, or about once every five years, said Brad McMillan, chief investment officer for Commonwealth Financial Network, in a note.

“Significant declines are a regular and recurring feature of the stock market,” he wrote. “In that context, this one is no different. And since it’s no different, then like any other decline, we can reasonably expect markets to rebound at some point.”

What awaits us?

Many market veterans are bracing for increased volatility. The Fed and its Chairman, Jerome Powell, signaled after their September meeting that policymakers intended to continue raising interest rates aggressively through next year and not to lower them until inflation will not have come down. Powell warned that getting inflation under control would be painful, requiring a period of below-trend economic growth and rising unemployment.

Many economists argue that the Fed cannot stimulate inflation without pushing the economy into a recession. Powell signaled that a severe downturn cannot be ruled out.

“Until we get some clarity on where the Fed is likely to end” its rate hike cycle, “I would expect to get more volatility,” Arone said.

During this time, there may be more shoes to drop off. The third-quarter corporate earnings season, which begins next month, could provide another source of downward pressure on stock prices, analysts said.

“We believe earnings estimates for 2023 should continue to decline,” Ryan Grabinski, investment strategist at Strategas, wrote in a note. “We have our chances of a 2023 recession at around 50% right now, and in a recession earnings drop on average around 30%. Even with some extreme scenarios – like the 2008 financial crisis when earnings fell dropped 90% – the median drop is still 24%.

The consensus earnings estimate for 2023 is down just 3.3% from its June highs, he said, “and we believe those estimates will be revised down, especially if the odds of a 2023 recession increase from here,” Grabinski wrote.

What to do?

Arone said sticking to high-quality, value stocks that pay dividends will help investors weather the storm, as they tend to do better during periods of volatility. Investors may also seek to approximate historical benchmark weightings, using the benefits of diversification to protect their portfolio while waiting for opportunities to put the money to work in the riskier segments of the market.

But investors need to think about their portfolios differently as the Fed moves from the era of easy money to a period of higher interest rates and quantitative easing gives way to quantitative tightening, with the Fed scaling back its balance sheet.

“Investors need to think about what could benefit from tighter monetary policy,” such as value stocks, small-cap stocks and shorter-dated bonds, he said.

How will this end?

Some market watchers say that while investors have suffered, the kind of full-throttle capitulation that typically marks market lows has yet to materialize, although Friday’s selloff did bring a whiff of panic at times.

The Fed’s aggressive interest rate hikes stoked market volatility, but did not cause a break in credit markets or elsewhere that would give policymakers pause.

Meanwhile, the U.S. dollar continues to rage, climbing over the past week to multi-decade highs against its major rivals in a move driven by Fed policy stance and the dollar’s status as a a safe place to park.

A pause in the dollar’s relentless rally “would suggest to me that the tightening cycle and some of the fear — because the dollar is a safe haven — is starting to fade,” Arone said. “We don’t see it yet.”

-William Watts

 

(END) Dow Jones Newswire

09-24-22 1437ET

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