Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 468

Bear markets don't go paw-in-paw with recessions

After a savage sell off over 2022, the S&P 500, along with other major indices, officially entered bear territory in June, or a fall of 20% or more from recent highs. Investors are now worried that the sell-off could be worse if the US and major economies tip into recession.

Yet while bear markets and recessions are often linked, from an investment perspective, they are distinct. Why?

Bears and recessions don’t always hunt together

Firstly, bear markets and recessions do not always coincide.

Worsening economic conditions do have an impact on the psychology of the markets, which are inevitably driven by sentiment as well as fundamentals. Investors often respond to fears of recession, or growing pessimism about the overall economy, by becoming more risk averse and reducing their exposure to equities.

Yet four of the bear markets after World War II did not lead to a recession. For instance, the two bear markets in the 1960s that did not prefigure a recession were driven by interventions by the Federal Reserve to tame inflation, which allowed the authorities to orchestrate a ‘soft landing’.

Gummy or Grizzly?

The recent fall in the market has been more severe than the average bear market and is close to a level that has, in the past, preceded a recession. It remains to be seen if this bear market will be a ‘Gummy Bear’: a shallow fall, or a ‘Grizzly Bear’: a deep fall.

Bear markets that come before recessions tend to bottom out and begin to recover before the recession is over. Quick recoveries also tend to happen if no recession ensues (dark grey line):

Taking a historical perspective, in the 12 U.S. recessions since World War II, the S&P 500 index has contracted from peak to trough by a median of 24%. If this were to be replicated, the S&P500 would fall to approximately 3,650. An average decline of 30% would reduce the S&P 500 to 3,360. (At time of publishing, the S&P500 closed on 27 July 2022 at about 4,000).

Falling valuations drive this bear market

So far, the US equity markets fall has mostly been about de-rating valuations (Price to Earnings ratios, or P/E) so they are appropriate for a more normalised 3-4% long-term interest rate environment.

Over the last 15 months, the historical earnings multiple of the S&P 500 has fallen from 32 times to 19 times, one of the swiftest and largest falls in valuation in history. The forward earnings multiple, which is based on expectations of future profitability, has fallen to around 16 times.

The current earnings multiples are still above the level hit by previous recession-linked bear markets, however. In the recession of 2020, the forward P/E ratio fell to 13 times and in the recession of 2008, it dropped to nine times.

The question now is, where to for earnings?

The market seems to be guessing whether harsher economic conditions will hit global corporate earnings, and, if so, how large the drop will be.

The picture will to some extent become clearer in the June quarter US reporting (during July/August) but will probably not be fully evident until after the September quarter reporting in October and November 2022.

Recession warning signs

The market is, however, flashing some warning lights about a recession.

One feature of this bear market, when compared with previous selloffs, is an unusually high level of volatility. About 20% of the trading days this year have seen the S&P 500 experience a price move greater than 2%. In the past 20 years, only 8% of annual trading days exhibited such volatility. It points to a high degree of uncertainty, although it should also be noted that about half of the turnover on the New York Stock Exchange is automated high-frequency trading, which could be contributing to the higher levels of activity.

Another indicator that may be of significance is that the dividend futures market is expecting that S&P 500 dividends will decline by nearly 5% in 2023. This points to a greater likelihood of a recession. For 60 years, S&P 500 dividends have not declined except during a recession.

Monetary policy will cause demand destruction and more rate rises are likely. The Federal Reserve is tightening monetary policy to rein in inflation, with 2022 seeing its most aggressive hikes since 1994 (another 0.75% increase in the Fed benchmark rate to 2.25%-2.50% was added on Wednesday 27 July).

But the rate is still low by historical standards and well below the June US annual inflation level of 9.1%. There are likely to be more rate rises given that real interest rates are in such strongly negative territory.

The era of cheap money, which has had a strongly positive effect on equity prices, seems to be over, at least while inflation is causing concerns.

Watching for the bottom

Past patterns are not always a guide and should be approached with caution. But they suggest that, although there is a risk that the market may have a way to go before reaching bottom, the severity and speed of the downturn suggest a substantial amount of the repricing has already occurred.

Historically, equities tend to stop declining when the market becomes confident that financial tightening has been sufficient, and the Fed has started easing rates. If a recession does occur, the case for increasing rates will become weaker, which may trigger such an easing.

Changes in the direction of inflation are another pointer to when the market has hit bottom. Equities on average decline when inflation is rising and approaching its peak, but they typically rebound quickly past that peak if a recession is avoided. If a recession materialises, history suggests that equities are likely to remain under pressure for six months after the inflation peak.

Using economy-wide data to identify when the market will hit its lowest point is especially flawed because of the difference between lagging indicators and future expectations.

One of the better indicators, though, may be high frequency employment data, which are a more specific economic measure. The bottom of the equity market has generally exhibited a relationship with the peak in weekly jobless claims. Since 1970, the S&P 500 has reached its local trough within weeks of the peak in weekly jobless claims.

The problem still though is a lack of consistency between jobless claim tops and equity market bottoms, and that often months can still separate them.

Markets tend to bounce strongly after bear markets

The good news is that this environment is throwing up opportunities and setting up stronger returns for investors.

It is an investment truism that generally the best time to buy, and the worst time to sell, is when the market has entered bear territory.

Looking at the S&P 500 bear markets that have occurred after World War II, the average one-year return after the bear market was 22%, which is almost double the average return over all periods.

The best short-term returns usually occur when the market bounces back.

The three-year return after a bear market was 14.25%; the five-year return was 13.17% and the 10-year return was 12.60%. In all these time periods the post-bear market returns were substantially above the average return for all periods:

Opportunities in small caps

The most common strategic response to tightening financial conditions, slowing economic growth, and elevated market volatility is to shift to big cap, stable companies with robust and predictable earnings streams.

But the flip side of this is that at the smaller end of the market this often creates greater mispricings that provide significant buying opportunities.

This time there has been some overly aggressive price falls of small caps. The selloff in the small and medium-cap sector has been greater than usual and they are, in relative terms, unusually cheap, trading at a historically big discount to large-cap companies.

We are now finding some wonderful businesses that were too expensive for us to own in the past but are now close to levels that we think provide great investment opportunities. We have seen these times before when indiscriminate and liquidity driven sell offs push down the valuations of some businesses to unsustainable levels given the strength of their underlying operations. We think this bodes well for investment returns for those that fit this mould during the inevitable market recovery.

But attempting to pick the bottom of a bear market can be counterproductive. Being a few days or weeks too late or too early can mean failing to outperform a buy and hold strategy.

 

Andrew Mitchell is Director and Senior Portfolio Manager at Ophir Asset Management, a sponsor of Firstlinks. This article is general information and does not consider the circumstances of any investor.

Read more articles and papers from Ophir here.

 

RELATED ARTICLES

7 truths of volatility, but are they friends or foes?

A tonic for turbulent times: my nine tips for investing

Anton in 2006 v 2022, it's deja vu (all over again)

banner

Most viewed in recent weeks

How to enjoy your retirement

Amid thousands of comments, tips include developing interests to keep occupied, planning in advance to have enough money, staying connected with friends and communities ... should you defer retirement or just do it?

Results from our retirement experiences survey

Retirement is a good experience if you plan for it and manage your time, but freedom from money worries is key. Many retirees enjoy managing their money but SMSFs are not for everyone. Each retirement is different.

A tonic for turbulent times: my nine tips for investing

Investing is often portrayed as unapproachably complex. Can it be distilled into nine tips? An economist with 35 years of experience through numerous market cycles and events has given it a shot.

Rival standard for savings and incomes in retirement

A new standard argues the majority of Australians will never achieve the ASFA 'comfortable' level of retirement savings and it amounts to 'fearmongering' by vested interests. If comfortable is aspirational, so be it.

Welcome to Firstlinks Edition 464 with weekend update

The 2021 Census reports that Millennials are now the largest generational group in Australia. While we are increasingly secular and culturally diverse, our differences are far more accepted than the way the US is heading. And please take our short retirement survey.

  • 30 June 2022

Dalio v Marks is common sense v uncommon sense

Billionaire fund manager standoff: Ray Dalio thinks investing is common sense and markets are simple, while Howard Marks says complex and convoluted 'second-level' thinking is needed for superior returns.

Latest Updates

Economy

The paradox of investment cycles

Now we're captivated by inflation and higher rates but only a year ago, investors were certain of the supremacy of US companies, the benign nature of inflation and the remoteness of tighter monetary policy.

Shares

Reporting Season will show cost control and pricing power

Companies have been slow to update guidance and we have yet to see the impact of inflation expectations in earnings and outlooks. Companies need to insulate costs from inflation while enjoying an uptick in revenue.

Shares

The early signals for August company earnings

Weaker share prices may have already discounted some bad news, but cost inflation is creating wide divergences inside and across sectors. Early results show some companies are strong enough to resist sector falls.

Property

The compelling 20-year flight of SYD into private hands

In 2002, the share price of the company that became Sydney Airport (SYD) hit 80 cents from the $2 IPO price. After 20 years of astute investment driving revenue increases, it sold to private hands for $8.75 in 2022.

Investment strategies

Ethical investing responding to some short-term challenges

There are significant differences in the sector weightings of an ethical fund versus an index, and while this has caused some short-term headwinds recently, the tailwinds are expected to blow over the long term.

Investment strategies

If you are new to investing, avoid these 10 common mistakes

Many new investors make common mistakes while learning about markets. Losses are inevitable. Newbies should read more and develop a long-term focus while avoiding big mistakes and not aiming to be brilliant.

Investment strategies

RMBS today: rising rate-linked income with capital preservation

Lenders use Residential Mortgage-Backed Securities to finance mortgages and RMBS are available to retail investors through fund structures. They come with many layers of protection beyond movements in house prices. 

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.