Stocks continued their descent last week, with the S&P 500 now well into bear market territory at -23% from the high. While most define bear markets as a decline of 20% from the high, some pullbacks just kiss that level or don’t result in widespread carnage across all sectors.
What we saw last week certainly qualifies the current situation as a “real” bear market. First, the S&P 500 was down almost 11% during the previous two weeks. Secondly, all sectors participated in the sell-off. Whether it is “profit-taking” or “selling what you can rather than what you want to,” this indiscriminate liquidation is the hallmark of a bear market. For example, energy stocks, which had been almost impervious to the market weakness this year, declined 17% last week! That still leaves energy up 31% and the only sector in the green year-to-date. Utilities, which were only slightly lower before last week, underperformed the market over the previous five trading days and were down 9%.
In the wake of hot inflation readings, the Federal Reserve (Fed) leaked its intent to raise interest rates by 75 basis points (0.75%) rather than 50 last week. The initial reaction to the Fed’s move on Wednesday was optimistic since it did not surprise the market, and Chair Powell put a good spin on the situation. But the reality remains that the odds are low that the Fed can tame inflation and avoid recession. The central bank is trying to move more quickly to tighten rates now so that it has room to ease policy once inflation is under control. Markets are currently pricing in another roughly two percentage points in higher short-term interest rates over the remainder of the year. The two best predictors of a coming economic downturn both moved toward a higher probability of a recession. There is more about the power of these two predictors here.
Bond spreads, the yield above U.S. Treasuries that investors demand to compensate for the risk of default, have moved to reflect the higher recession risk and market turmoil. High yield, or junk, bond spreads rose sharply over the last two weeks, consistent with pre-recession and bear market behavior.
Baa, the lowest credit rating for investment grade, bond spreads typically move closely with the stock market movements.
The sharp decline in stocks has made the valuation more reasonable. As a simple measure, the dividend yield of the S&P 500 has risen to 1.74%. While the dividend yield of the S&P 500 is no longer higher than the 10-year U.S. Treasury, that is a function of the 10-year yield moving higher at a more rapid pace. Historically, the dividend yield was typically below the 10-year yield until the ultra-low interest rates were ushered in by the Global Financial Crisis.
A silver lining to this dour review of the stock and bond market damage is that a decent amount of bad news is baked into asset prices now. In the previous twelve recessions, stocks have typically declined by 24%, so the S&P 500 is very close to pricing in a typical economic slowdown. Credit markets, via bond spreads, have also moved toward discounting the market turmoil and a possible recession. The better news is that future stock returns have historically been elevated after a bear market decline of at least 20% from the peak. Dividend yields, an essential part of the total return from stocks, should already provide higher income. It would not be a surprise to see a market bounce in the short-term after the indiscriminate selling last week, but it is a fool’s errand to forecast a durable end of the declines. Timing the end of a bear market is impossible, but the rebound is typically explosive and happens before the economy recovers.