US Stocks Are On The Brink Of A Bear Market. A Recession Might Be Next.

US Stocks Are On The Brink Of A Bear Market. A Recession Might Be Next.
Reda Farran, CFA

almost 2 years ago3 mins

  • The S&P 500 is on the brink of bear market territory – a drop of 20% from its peak – with two technical indicators suggesting further falls are ahead.

  • Over the past 95 years, bear markets have usually preceded recessions, partly because of what they signal about the future and partly because of the wealth effect.

  • Since 1950, the average stock market decline in a non-recessionary bear market was 27.4%, compared with 37.6% when a recession came with a stock rou

The S&P 500 is on the brink of bear market territory – a drop of 20% from its peak – with two technical indicators suggesting further falls are ahead.

Over the past 95 years, bear markets have usually preceded recessions, partly because of what they signal about the future and partly because of the wealth effect.

Since 1950, the average stock market decline in a non-recessionary bear market was 27.4%, compared with 37.6% when a recession came with a stock rou

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It’s been a rough ride for the S&P 500: the index is on a six-week losing streak, it’s given up more than $10 trillion in market capitalization, and it’s on the brink of a bear market. And now, two indicators point to even more of a drop, suggesting that a recession is imminent. Let’s see what that means for your portfolio.

What are the technical indicators showing?

First, as bad as things look already, the S&P is still trading about 15% above its 200-week moving average – a level that’s been a kind of support during previous bear markets, except for the dotcom crash in 2000-2002 and the global financial crisis in 2008-2009. That suggests that the index is likely to fall another 13% before it meets any real resistance.

The S&P 500 is still trading above its 200-week moving average. Source: Bloomberg
The S&P 500 is still trading above its 200-week moving average. Source: Bloomberg

Second, here’s a key “stress indicator”: it measures how many S&P 500 members have recently notched a new 52-week low. And it’s not at levels seen during comparable market slumps. Fewer than 30% of the S&P 500’s members have done so, compared with nearly 50% during the growth scare in 2018 and 82% during the global financial crisis in 2008.

Fewer than 30% of the S&P 500’s members have hit a new one-year low. Source: Bloomberg
Fewer than 30% of the S&P 500’s members have hit a new one-year low. Source: Bloomberg

Here’s the thing: Big Tech represents a hefty slice of the S&P, and that sector has been hit hard by the recent market rout. But there are all these other stocks that still have further room to fall (evidenced by the fact that only 30% of the S&P's members are at one-year lows) and drag the wider index with them.

Can the market predict a recession?

While most forecasters are predicting that the US economy will resume expanding and avoid a recession, stocks themselves do become recession warning indicators when they enter a bear market. That’s partly because of what they signal about the future (weaker corporate profits due to falling economic growth), and partly because of what shrinking investment accounts do to consumer sentiment and spending (the so-called wealth effect).

In fact, one study found that for every dollar of increased stock market wealth, consumer spending – the biggest driver of the US economy – rises by 3.2 cents. As you can imagine, this works in reverse too.

Is there always a bear market before a recession?

We can look back at history to see if bear markets always precede recessions. The S&P 500 has completed the required 20% drop that defines a bear market 14 times in the past 95 years. On 12 of those occasions, within a year, the US economy went on to shrink for two consecutive quarters (the definition of a recession). The only two times it didn’t were in 1966 and after the infamous 1987 flash crash known as “Black Monday”.

On the flip side of this indicator: among the 15 recessions that took place over the past 95 years, 12 were accompanied by a bear market. The summary: bear markets and recessions often go hand in hand.

Now, whether the US economy enters recession has obvious economic implications – and there are also implications for stocks. It makes sense: a recession not only dents sentiment further, but also leads to a big drop in consumer spending, manufacturing activity, and more – all of which exacerbates the stock market selloff.

History backs this up: according to data by John Hancock Investment Management going back to 1950, the average stock market decline in a non-recessionary bear market was 27.4% compared with 37.6% for when a recession came with a stock rout.

So is the US economy headed for a recession?

That’s the million-dollar question, because if the answer is yes, history suggests that stocks still have further room to fall.

If we look at all the recessions since World War II, many of them had four things in common. And most of those things are present today. They are: a rate-hiking cycle by the Fed (check), an inverted yield curve (check), geopolitical tensions (check), and a bear market (almost check).

One way to hedge your portfolio against the possibility of a recessionary bear market is to purchase out-of-the-money put options on stock market ETFs, like the SPDR S&P 500 ETF Trust (ticker SPY, expense ratio: 0.09%).

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