US equity bear markets: how long do they last?

AJ Bell press comment - 14 June 2022

“There is an old market saying that, ‘first they come for the lieutenants and then they come for the generals,’ and this is exactly what we are seeing in US equities right now,” says AJ Bell Investment Director Russ Mould. “The more speculative small-cap and earlier-stage indices of the Russell 2000 and NASDAQ peaked and entered bear market territory first and now the S&P has joined them. That leaves just the Dow Jones Industrials.

Source: Refinitiv data

“When trouble starts, investors start to rein in risk and head for what they hope will be a safe haven. In stock market terms that means shifting from indices packed with small caps or more speculative, early-stage firms toward large and mega-caps whose finances are more robust. Sure enough, the Dow is where bulls are making their stand, even if history suggests it may be a futile gesture, especially as previously reliable mega-caps like Apple and Microsoft are starting to crack.

Source: Refinitiv data

“So far the indices have been cut down in their traditional order for a bear market. This now begs the question of how long the downturn lasts.

Previous bear markets

“The S&P 500 is entering is twelfth bear market since 1950. The previous eleven typically lasted for 390 days and resulted in an average decline of 34% from top to bottom. Even an average bear market could therefore see more damage from here, as a 34% decline would take the S&P 500 to 3,147 from Tuesday’s close of 3,750, a further drop of 18%.

Source: Refinitiv data

The bigger the party the worse the hangover

“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. Judging by the action in IPOs, SPACs, meme stocks, cryptos, loss-making companies and other highly speculative areas through 2020 and 2021, the party this time around was a big one.

“It may have been the shortest bull run on record since 1950, at just 651 days, but the S&P 500 still more than doubled in that period, so what it lacked in duration it made up in intensity. 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 As soon as that stimulus faded or was withdrawn, asset prices stalled very quickly.

Source: Refinitiv data

“A reading on the ‘fear index’, or VIX, of 33 may persuade some to take a contrarian, bullish stand, especially as that benchmark’s long-run average is 19.5. But even 33 may not necessarily be enough to truly call a market bottom, even if it could lay the foundations for a near-term rally.

Source: Refinitiv data

“In a bear market, such rallies can be little more than agonising traps for unwary bulls. The hammering taken by buyers of technology, media and telecoms (TMT) stocks who kept the faith during 2000-02 as the bubble collapsed found that out the hard way. There were nine major rallies during that downturn, for a cumulative gain of 4,886 points on the NASDAQ and an average advance of 23%. Yet none of them prevented the tech-laden index from its top-to-bottom 78% meltdown, from 5,049 in March 2000 to 1,114 in October 2002.

Source: Refinitiv data

Margin call

“The danger is that losses in one holding force investors to sell another, either to cover those losses or meet a margin call for those that have been willing to borrow in their efforts to speculate and accumulate. That is how all correlations end up going to one, as troubled portfolio builders look to sell anything they can lay their hands on. That usually means the most liquid assets – typically those highly liquid assets into which they have gathered looking for safety, including mega-cap stocks and indices like the Dow Jones Industrials.

“Margin calls can become a particular problem - as some cryptocurrency holders are now discovering - and margin debt data from US regulator FINRA suggests this process of liquidation is beginning, as it looks like investors in US equities are starting to cut borrowings and take less risk. Whether they are doing this willingly or at the behest of their brokers’ risk officers is harder to divine.

Source: FINRA, Refinitiv data

“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 American economy started to slow and then culminated as the COVID-19 pandemic hit home. 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.”