There is another action to come in this market drama

Head writer of Rockefeller International

US stocks tumbled off the brink – the 20 per cent drop that defines a bear market. Now a lot of people are wondering how this drama ends, which is still the worst start in any year since 1970. My point is that this is the break, and that the next chapter is going to go down one more step.

The previous patterns indicate the same amount. S&P 500 records going back to 1926 show a total of 15 bear markets, with an average decline of 34 percent over 17 months. In nearly 75 percent of these cases — 11 of 15 — selling paused significantly when the market fell 15 to 20 percent from its peak, reversing some of the losses before resuming the journey to the bottom. This roughly plotted date indicates that what we are witnessing is a resting phase of a bear market.

There are other factors pointing the same way. The last retracement scale, near the double digits, aligns with bear market pauses, and therefore is not necessarily a sign that the declines are over.

In 11 bear markets that were halted by a pause, the average length of the pause was four months. Moreover, this time around, the Federal Reserve is unlikely to come to the rescue of the markets – and not with interest rates remaining well below the rate of inflation.

What caused the market slump this year was more than the usual suspect – Fed tightening. Rather, it was the realization that this tightening heralded the end of an era. With inflation picking up and anything but temporary, as the easy money crowd has long argued, the Federal Reserve cannot easily pull back to reassure investors, as it has done for more than three decades.

The Fed’s action or inaction can determine whether the market is in bearish territory. Since 1926, there have been five instances–separate from bear markets–in which stocks have fallen by about 20 percent but never gone beyond that.

In all five countries, the market stopped falling only when the Fed intervened, easing monetary policy. Four of them came in the last era of progressively easier money — in 1990, 1998, 2011 and 2018. But now, a Fed bailout is highly unlikely, unless the economy slips into recession and inflation pulls out of inflation.

However, a recession could cause deeper problems for the market. As consumer confidence and other indicators turn for the worse, the chances of a downturn increase.

In recent decades, amid rapid financing in the economy and constant Fed bailouts, bear markets have become less frequent, but more severe and likely to be accompanied by a recession.

Of the 15 bear markets, 11 also coincided with recessions, including six of the last seven, dating back to 1970. Bear markets that accompanied recessions saw an average decline of 36 percent over 18 months, compared to 31 percent Over 10 months for those who weren’t.

The reason why bear markets so often come to a halt is fundamental: Markets don’t move in straight lines, and it takes time to break an established investor’s psyche. Although many institutional investors are reducing their holdings of stocks, retail investors are hardly holding back so far.

During April, retail investors were still pumping money into US stocks and exchange-traded funds at or near record pace, $20 billion to $30 billion a month. One popular tech fund had withdrawn $1.5 billion as of late May, even as it was losing half its value. Belief with this intensity is rare, but it can suddenly be overturned.

So far, stock valuations have fallen because prices are falling — despite resilient earnings. Even with the market down this year, the continued drumbeat of upbeat earnings expectations has kept the low buying mentality alive. An economic downturn may end this decline in profits and the confidence of retail investors.

Bulls have their reasons. They point to years like 1994, when the economy was so strong that Fed tightening led to a mild slowdown and only a 10 percent fall in stocks. Or they chart ways that inflation could subside, as shortages caused by the pandemic and war in Ukraine somehow disappear, allowing the Federal Reserve to stop tightening relatively soon.

But for now, market stability is strengthening the resolve of the Federal Reserve, which began “quantitative tightening” last week, a move that could pave the way for the second act of this drama. Given all the risks lurking in the wings — persistent inflation, slower growth, bubble traders — it would take a magical outcome for the next action to be shorter or less severe than the typical bear market of the last century.