It’s official. Today the S&P 500 entered a bear market as the index fell 20% from it’s recent high. How should you react to this as an investor?
What’s Driving The Bear Market?
First it’s helpful to understand what’s driven this change in markets. The primary reason is the Fed sharply raising rates in reaction to high inflation. The Fed have raised rates all ready, but markets expect many more hikes throughout 2022. This is why the sell off has so far been more concentrated in growth stocks. Increasing discount rates have caused markets to focus more on earnings now than earnings in the future. Value is outperforming growth currently, though most stocks are down.
A secondary concern is the risk of recession. Growth was negative for the U.S. in the first quarter and the Fed raising rates can quite often lead to a recession. Ironically one of the best indicators of a recession is the stock market itself. This sort of a drop in markets can signal a recession is coming. That said, U.S. jobs data remains reasonably robust for now with unemployment at 3.6%, so a recession is not a certainty and may be mild if current trends hold.
Thirdly, stock valuations had become relatively expensive compared to history over recent years. With stocks trading well above historical valuation levels, some reversion to lower valuations over time was a possibility, even if the timing was uncertain.
Finally, there are a host of other concerns. The Ukraine conflict has shaken global stability, pushed up prices and disrupted supply chains. China’s economy is relatively weak currently, and a strong dollar doesn’t help foreign earnings of most S&P 500 firms.
What To Expect
First off, a bear market is primarily a historical observation. With the start of a bear market we are saying stocks have fallen at least 20% recently. As always with markets its far easier to say what has happened that what’s coming. Still there are a few trends that tend to hold in most bear markets.
Volatility and Style Shifts
However, bear markets are typically accompanied by greater volatility in daily price movements and a focus on stability and value stocks over speculation and growth stocks. As such one of the trends we’ve seen in 2022 is value stocks outperforming growth.
However, bear markets are often a time for fixed income to shine. That hasn’t happened so far. The bond markets has generally sold off in 2022 so far as the Fed has signaled aggressive plans to hike rates. This means that the usual protection to a portfolio of holding stocks and fixed income has been less successful. Yes, bonds have generally fallen less than stocks, but both have lost money in 2022.
As in most markets, diversification can help smooth your returns in a bear market. Holding a mix of assets and countries can help make sure that you aren’t exposed to the worst losses in a bear market. Currently U.S. growth stocks are among the hardest hit but other regions, styles and assets are fairing better.
Painful as it is, short term drawdowns are part of stock investing. They always have been. Bear markets are never easy, but they aren’t unusual. However, historically the returns to owning a diversified portfolio of stocks has been attractive.
If you don’t need the money you are investing in stocks for many years, then you’re still likely to come out ahead if history is any guide even with bear markets along the way. There are many examples historically of U.S. stocks losing money during a single year. Yet, over a 5-10 year horizon such losses are possible, but less common.
So while the bear market lasts, we may expect some volatility with value-oriented stocks and fixed income likely outperforming. However, history also suggests that pain in the markets will be temporary. Ultimately stocks have tended to beat out other asset classes over the long term for those that can ride out bear markets.