The market is ripe for a protracted bearish trend

With the S&P 500 briefly down 20% on Friday from its January peak, the temptation is great to announce the end of the sell-off. The problem is that there is only one condition for a rally: everyone is scared. This has been a great help in determining the start of a recovery in 2020, but it may not be enough right now.

Other factors suggest that investors should see a solution to the problem, and politicians should start helping them. Without these conditions met, a series of bear market rallies could occur that would not last long, but hurt buyers and further undermine investor confidence.

Moreover, trust is already at a low level. Sentiment polls show that fund managers (Polled by Bank of America), private investors (American Association of Individual Investors) and financial newsletters (Investors Intelligence) have already reached the March 2020 level of caution on stocks. In addition, various options are also popular now that protect against a market fall. At the same time, according to the University of Michigan, consumer sentiment is actually worse than then.

That was enough in 2020 because central banks and politicians were scared too. Thanks to their intervention, investors realized that companies could overcome the crisis with government support.

This time around, central banks fear not falling markets or economic forecasts, but inflation. Of course, if something serious happens in the financial system, they will shift their focus to finance, and a recession may prompt them to reconsider raising rates. But for now, inflation means falling stocks are seen as just a side effect of monetary tightening, not an excuse to use the Fed’s put to bail out investors.

There is nothing incredible about a 20% drop, which is natural for a bear market. But that happens all too often: Over the past 40 years, the S&P 500 has bottomed out with peak-to-trough drops of 20% or so four times: in 1990, 1998, 2011, and 2018. Four more times, he suffered much greater losses, as the market was seized by a real panic.

In all cases of a 20% drop, the Fed was the culprit. Each time the market bottomed out when the central bank eased monetary policy, and the stock market crash may have made the Fed take threats more seriously than it otherwise might have.

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Current differences

However, the current case may be more similar to 1973-1974. As then, the country is mainly focused on inflation caused by the surge in oil prices due to the military conflict. As then, the inflationary shock intensified when the Fed set rates too low given the scale of the policy stimulus to the economy. As then, the preferred stock — Nifty Fifty, and now FANG and its accompanying acronyms — has skyrocketed in previous years.

Most importantly, in 1974 the Fed kept raising rates even as the recession hit as it tried to get closer to the rate of inflation. The result was a terrible bear market that was punctuated by exhausting temporary rallies, two reaching 10%, two 8%, and two 7%, both of which ended soon. It took 20 months before the low was hit – no coincidence that the Fed finally started to get serious about cutting rates.

So far, this period has not been all that bad for equities, not least because the economy is not in recession. If inflation eases, the Fed won’t need to raise rates as much as it had planned, which would support the affected stocks.

It remains to be hoped that the economy will turn out to be stable, although it will be a long time before a good bet can be made. However, in layman’s terms, after stocks have more than doubled in two years, a market drop of more than 20% seems likely.

Prepared by based on The Wall Street Journal

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