There is another act to come in this market drama

The writer is chair of Rockefeller International

US stocks have pulled back from the edge of the cliff — the 20 per cent drop that defines a bear market. Now many people are wondering how this drama, still the worst start of any year since 1970, ends. My view is that this is the intermission, and that the next act will bring another step down.

Past patterns suggest as much. Records for the S&P 500 going back to 1926 show a total of 15 bear markets, with a median drop of 34 per cent over 17 months. In nearly 75 per cent of these cases — 11 of the 15 — selling paused noticeably when the market was down 15 to 20 per cent from the peak, reversing some losses before resuming the trip to the bottom. This roughly sketched history suggests that what we are witnessing is the intermission stage of a bear market.

There are other factors pointing the same way. The scale of the recent bounce, near double digits, is in line with past bear market pauses and thus not necessarily a sign that the declines are over.

In the 11 bear markets that were interrupted by a pause, the median length of the pause was four months. Further, this time the US Federal Reserve is unlikely to come to the rescue of the markets — not with interest rates still well below the rate of inflation.

What triggered this year’s market fall was more than the usual suspect — Fed tightening. Rather, it was the realisation that this tightening foretells the end of an era. With inflation resurgent and anything but transitory, as the easy money crowd has long been arguing, the Fed cannot easily back off to reassure investors, as it has for over three decades.

Fed action or inaction can determine whether a market falls into bear territory. Since 1926, there have been five cases — separate from the bear markets — in which stocks fell nearly 20 per cent but didn’t cross that threshold.

In all five, the market stopped falling only when the Fed intervened, loosening monetary policy. Four came within the recent era of progressively easier money — in 1990, 1998, 2011, and 2018. Now, however, a Fed rescue is highly unlikely, unless the economy skids into recession and takes the wind out of inflation.

A recession would, however, spell even deeper trouble for the market. And as consumer confidence and other indicators turn for the worse, the chances of a downturn are growing.

In recent decades, amid rapid financialisation in the economy and constant Fed rescues, bear markets became less frequent, but more severe and more likely to be accompanied by recessions.

Of the 15 bear markets, 11 have also coincided with recessions, including six of the last seven, dating to 1970. Bear markets that were accompanied by recessions saw a median decline of 36 per cent over 18 months, compared with 31 per cent over 10 months for those that were not.

The reason bear markets often pause for intermission is basic: markets do not move in straight lines, and it takes time for entrenched investor psychology to break. Though many institutional investors have cut stock holdings, retail investors have barely flinched so far.

Through April, individual investors were still pouring money into US stocks and exchange traded funds at or near a record pace, $20bn to $30bn a month. One popular tech fund had drawn $1.5bn through late May, even as it was losing half its value. Faith of this intensity is rare but can turn suddenly.

So far, stock valuations have come down because prices are falling — despite resilient earnings. Even as the market dropped this year, a continuing drumbeat of optimistic earnings forecasts has kept the dip-buying mindset alive. A downturn in the economy could end this run for earnings, and retail investor confidence.

Bulls have their reasons. They point to years like 1994, when the economy was so strong that Fed tightening triggered just a mild slowdown and a mere 10 per cent drop in stocks. Or they sketch ways that inflation could subside, as shortages induced by the pandemic and the war in Ukraine somehow disappear, allowing the Fed to stop tightening relatively soon.

For now, however, a stabilised market is stiffening the resolve of the Fed, which began “quantitative tightening” last week, a move that could set the stage for act two of this drama. Given all the risks lurking in the wings — persistent inflation, slower growth, bubbly traders — it would take a magical outcome for the next act to be shorter or less severe than the typical bear market of the past century.