Bear market: What it means for investors and when it could end?

Investors who have heavily relied on the US stock market for returns over the past decade have been given a wake up call as the S&P 500 officially slipped into a bear market.

Wall Street is struggling with the impact of the war in Ukraine, rocketing energy costs, rising interest rates and inflation which has hit a 40 year high.

On Monday, the S&P 500 fell almost 4 per cent putting it 21 per cent below its peak in January and into bear market territory.

The sell-off came amid reports the Federal Reserve could raise interest rates by as much as 0.75 percentage points this week. It would represent the biggest single hike for nearly 30 years.

‘There is a lot riding on the Federal Reserve’s policy update tomorrow. 

‘Investors look as if they increasingly fear the central bank will become more aggressive with the pace of interest rates to try and curb inflation, given May’s cost of living figures were higher than expected,’ says AJ Bell’s investment director Russ Mould.

The last CPI figures published last week showed that the cost of living increased 1 per cent from April, ahead of expectations, as food, gas and shelter costs rise.

‘The Fed is focused on inflation and the economy, not the markets, yet its actions have significant influence on the direction of stocks and bonds,’ says Mould. 

‘A decision to raise rates by more than half a percentage point could cause chaos on the markets and put a bigger dent into investors’ portfolios than they’ve already seen this year.’

The US producer prices index (PPI) published today, showed signs of slowing which may quell some nerves.

What happens next?

Bear markets are fairly common. The S&P 500 is entering its 12th bear market since 1950 and its second in two years, after the pandemic shuttered the economy.

The index fell 34 per cent between February and March 2020 as investors reacted to lockdown restrictions. However, it was over in 33 days.

A bear market may come as a surprise to the new generation of investors who started trading primarily through commission-free trading apps like Robinhood during the pandemic when stocks surged.

What next for the S&P 500 then? ‘History tells us there is still a way to go yet,’ says eToro’s global markets strategist Ben Laidler. ‘Recession risks are rising and could see this market fall another 20 per cent.

‘Indeed the average S&P 500 bear market, few and far between, lasts 19 months and sees a 38 per cent drop in prices. This one has only lasted five months and is down 21 per cent.’

And it isn’t looking good for the rest of the market. The small-cap and earlier stage indices of the Russell 2000 and Nasdaq are already in a bear market, with the Nasdaq down 31 per cent from its peak last November.

The previous 11 bear markets typically lasted for 390 days and resulted in an average decline of 34 per cent from top to bottom, according to AJ Bell analysis.

Mould adds: ‘Even an average bear market could therefore see more damage from here, as a 34 per cent decline would take the S&P to 3,147 from Monday’s close of 3,750, a further drop of 18 per cent.’

‘The other factor investors need to consider here is the bull run that precedes the bear tumble. You could argue that the bigger the party, the worse the hangover.’

While the bull run has been the shortest on record at just 651 days, the S&P 500 more than doubled in the two-year period.

‘That in itself may be a clue to its source, given the huge amount of fiscal and monetary stimulus provided by Government and central banks. 

‘As soon as that stimulus faded or was withdrawn, asset prices stalled very quickly.’

Should we be worried about a recession?

A bear market does not necessarily lead to a recession but rising inflation does mean investors are growing increasingly concerned.

The Federal Reserve has indicated it is moving away from propping up the markets, instead focusing on inflation. 

There is a risk, however, that the US could soon face a recession if interest rates are too high or raised too quickly.

‘A recession is not inevitable. US growth is resilient so far, consumers have big savings, and companies are near record profit margins. 

‘The sell-off has been solely valuation driven, taking price/earnings valuations to near 16 times below 10-year averages,’ says Laidler.

‘A missing ingredient of a recession has been weaker earnings, which in such times traditionally fall over 20 per cent, but in fact they have risen this year. 

‘Companies have not yet received the recession memo, but are not immune to the gathering storm clouds.’

Even if a recession is avoided, interest rate hikes will still put pressure on US stocks particularly high-growth tech stocks.

One of the dangers Mould highlights is that losses in one holding force investors to sell another, either to cover the losses or meet a margin call.

Margin debt data from the US regulator suggests a process of liquidation is already beginning as investors in US equities are starting to cut borrowings and take less risk.

‘Right now, the drawdown in margin debt looks modest compared to the last two big US equity bear markets of 2000-02 and 2007-09 and the wobble of 2019-20 which began as the US economy started to slow and then culminated as the Covid-19 pandemic hit home.

Mould adds: ‘But that could mean, in a worst case, there is more forced selling to come, unless the authorities step in to support the markets with rate cuts, QE and stimulus packages – although the fight against inflation makes that less likely right now, in contrast to 2000-2002, 2007-2009 and 2020-21 when central banks threw everything that they could at bear markets and recessions.’