Earlier this month, the S&P 500 officially entered bear market territory. A bear market is an extended period of prolonged price declines in the stock market. It is typically defined as a decline of at least 20% from recent highs for stock market indexes such as the S&P 500, the Dow Jones Industrial Average or the Nasdaq composite. The S&P 500 hit an all-time high of 4,818 early this year, but concerns over persistently high inflation, aggressive Federal Reserveinterest rate hikes and the prospect of a U.S. economic recession had the S&P 500 trading back down around 3,911 in late June.
Bear markets are relatively common in the history of the U.S. stock market, often accompanying U.S. economic recessions. Bear markets can be extremely scary for investors who are watching their portfolios seemingly evaporate on a daily basis. However, they have historically been no cause for panic for long-term investors with diversified portfolios of high-quality stocks and the discipline to weather the storm. Bear markets are a natural part of the U.S. economic cycle, and they can even serve as excellent opportunities for investors who understand the long-term relationship between stock prices and the fundamental performance of the underlying companies. Here are seven things investors should know about bear markets:
— Bear markets are excellent buying opportunities.
— Bear markets typically don’t last long.
— The S&P 500 has averaged a 29.8% decline during bear markets.
— Bear markets associated with recessions are much worse.
— Bear markets are part of healthy market cycles.
— Beware the bear market rally.
— Stocks will rebound before the economy.
Bear Markets Are Excellent Buying Opportunities
Historically, bear markets have provided investors with excellent opportunities to buy high-quality stocks at a discounted valuation. When the entire stock market falls, even most high-quality stocks are dragged down with it. Assuming the overall market eventually recovers, this downdraft in stock valuations provides investors with periodic opportunities to scoop up shares of some of the best stocks in the market at a cheap price relative to their longer-term earnings and cash flow outlooks.
In fact, Ryan Detrick, chief market strategist for LPL Financial, says buying stocks on the day the S&P 500 transitions to a bear market has historically generated relatively good one-year returns. Since 1950, the S&P 500 has averaged a nearly 15% return in the 12 months after it entered bear market territory, according to LPL. Of course, past performance is no guarantee of future returns, and Detrick says there are a handful of exceptions to the rule. The S&P 500 generated a negative return in the year following the beginning of the 1973 recession, the dot-com bubble in 2000 and the global financial crisis in 2008.
“The good news is we don’t see an economy like that over the next year, so the likelihood of higher prices (maybe significantly higher) is quite strong, in our view,” Detrick says.
Bear Markets Typically Don’t Last Long
Another thing investors should remember to keep bear markets in perspective is that they haven’t historically lasted very long. In fact, the average S&P 500 bear market since 1950 has lasted just 11 months, according to LPL Financial. Given that bear markets begin at the peak of the previous bull market, the current bear market technically began back in January.
“At more than five months old, it is already older than six other bear markets going back nearly 40 years,” Detrick says.
In fact, the only bear markets since 1982 that have lasted longer than the current one are the dot-com bubble and the 2008 financial crisis. The bear market during the initial weeks of the U.S. COVID-19 pandemic in 2020 lasted a little over a month.
While all the financial media headlines about an S&P 500 bear market may have come in the past couple of weeks, Detrick says there’s a real possibility that the worst of the bear market may already be in the rear-view mirror.
When the financial media declares an official bear market, it can understandably be scary for investors because of the prospect of additional losses. However, a 20% loss is already a significant decline. From a historical perspective, the S&P 500 typically has limited additional downside once it hits the 20% mark.
The S&P 500 Has Averaged a 29.8% Decline During Bear Markets
It may feel like the sky is falling and your portfolio is going to zero during a bear market. However, since 1950, the average bear market decline is only 29.8% from previous highs, according to LPL Financial.
Crunching the numbers on the 2022 situation based on historical averages may be a reassuring exercise for investors. Applying the 29.8% peak-to-trough historical bear market average for the S&P 500 to the current situation, the current bear market would bring the S&P 500 down to around 3,382 before the market finds a bottom. From current levels, that 3,382 bottom would represent only about 13.5% additional downside. Compared to the average historical 12-month return for the S&P 500 once it enters bear market territory (14.8%), some investors may see that 13.5% potential downside as a risk worth taking to buy the dip.
Bear Markets Associated With Recessions Are Much Worse
LPL Financial breaks down its analysis of previous S&P 500 bear markets into two categories: bear markets associated with economic recessions and bear markets not associated with economic recessions. Since 1950, there have been eight S&P 500 bear markets that were not associated with a U.S. economic recession. Those eight bear markets that didn’t coincide with a recession produced an average peak-to-trough S&P 500 decline of just 23.8%.
An economic recession is defined as two consecutive quarters of negative U.S. gross domestic product growth. The U.S. reported a surprise 1.4% decline in GDP in the first quarter of 2022.
Assuming the U.S. avoids a recession and the historical trends hold, there may be very little additional downside for the S&P 500 in its current bear market.
Unfortunately, there are historical exceptions as well. In 1987, the S&P 500 experienced a 33.5% pullback during a bear market that was not associated with a U.S. recession.
Fortunately, Detrick is not anticipating a U.S. recession in 2022. “Yes, 1987 is in there, but most of the other times stocks bottomed near where we are now, suggesting potentially limited pain from current levels,” he says.
Bear Markets Are Part of Healthy Market Cycles
Bear markets may be scary, but it’s important to understand that the U.S. stock market is cyclical in nature. There’s nothing inherently wrong with a downturn in the economy or the stock market. In fact, bull markets and bear markets have historically been regular occurrences throughout the history of the S&P 500.
Stocks are subject to a phenomenon known as the investor sentiment cycle. Since 1975, the rolling annual 30-year return of the S&P 500 has always stayed between around 8% and 13.6%. That return has been remarkably consistent over the long term. However, as most investors have experienced, there have been plenty of wild swings in the S&P 500 over one- or two-year periods.
These short- and medium-term swings in stock prices and valuations are part of the investor sentiment cycle. Stock prices are driven by supply and demand, and the demand element of that equation has a major psychological component.
“Be fearful when others are greedy and greedy when others are fearful,” investing guru Warren Buffett once famously said. During bear market cycles, it’s natural to feel fearful, desperate and pessimistic. The difficult part about navigating a bear market is that the best thing to do historically during these troughs in the investor sentiment cycle is to buy stocks, not sell.
Beware the Bear Market Rally
It may be a good idea for investors to buy the dip in high-quality stocks during a bear market and hold on for the long term, but shorter-term traders should beware a phenomenon known as the bear market rally. A bear market rally is a sharp, short-term rally in stock prices within a bear market. Bear market rallies are also sometimes called dead cat bounces, sucker rallies or bull traps.
Price action in financial markets is rarely perfectly smooth, and market dynamics trigger periodic retracements during both bull and bear markets. The key to successfully navigating this noise is understanding these periodic bear market rallies are often short-lived.
John Lynch, chief investment officer for Comerica Wealth Management, says S&P 500 bear market rallies are common, large and fleeting. He points to a study by Strategas Research Partners referencing data since 1950 that indicates the average bear market rally sees gains of approximately 15% and lasts about two months.
Traders too eager to declare the bear market bottom are running the risk of falling victim to a bear market rally.
Stocks Will Rebound Before the Economy
The stock market is a leading economic indicator, meaning stocks will recover before U.S. economic data does. Assuming the U.S. avoids a recession, stock prices will likely be dictated by market expectations related to economic data associated with inflation and interest rates. In May, the Labor Department’s consumer price index was up 8.6% from a year earlier, the highest inflation reading since 1981. In response, the Federal Open Market Committee raised interest rates by 0.75 percentage point in June, its largest interest rate hike in 28 years.
Inflation is enemy No. 1 for the Federal Reserve at this point, and interest rates are likely still headed significantly higher from current levels. However, investors shouldn’t wait for the economy to improve to start buying stocks. The stock market is a leading market indicator because stock prices reflect aggregate expectations for the future rather than current economic conditions. It may take a long time for the Fed to get inflation under control and back in line with its 2% target, but the S&P 500 will likely begin to rebound as soon as investors start to see light at the end of the inflation tunnel.
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7 Things Investors Should Know About a Bear Market originally appeared on usnews.com