• Nicholas Pihl

What to Know About Bear Markets

Updated: 1 day ago

The biggest thing to remember about bear markets is that nothing lasts forever. That's good news, because there are a lot of things going badly right now. But even as bad news captures the headlines, it's important to remember that things can work out for the better too.

Let's review why some investors are pessimistic

Big picture, markets are declining due to uncontrolled inflation. This has led to higher interest rates, and heightened risk of a recession. All three of these factors are bad for asset values.

Higher interest rates reduce corporate profits. One graphic making the rounds suggests that 30% of all earnings growth over the past 30 years has come from lower interest payments on debt. This suggests future growth will be lower, and potentially that near-term earnings will be impaired by higher financing costs.

Mortgage rates are rising, which makes housing less affordable and puts downward pressure on property values. This, in turn, has lead to diminished construction of new homes, impairing a key driver of the US economy.

The dollar is extremely strong too, which puts pressure on exports and reduces the value of overseas profits. (If you earn one Euro of profit, that's worth just $1 today, compared with $1.15 a year ago).

Energy prices remain high, due partly to a hot economy and partly due to sanctions on Russia. This also reduces profitability for everyone (except energy companies, which are doing quite well).

Labor is still hard to find, and increasingly expensive.

As expenses rise for essentials, that leaves less money for discretionary purchases (on the consumer side), and strategic investments (on the business side). This has ripple effects throughout the economy.

Part of that expense-cutting includes reduced advertising budgets. This affects advertising mammoths like Google, Meta, Amazon, and even Apple. These companies comprise a large portion of the S&P 500, so impaired earnings at these firms could hurt the valuation of the market as a whole.

On top of which, even among smaller firms, many once-promising tech ventures have seen slowing growth rates, and have felt downward pressure on their valuations. Some of the more speculative ventures may never see their stock prices recover fully.

Each new inflation report has the potential to further disappoint investors, as continued high inflation would seem counter to the notion that this bought of inflation is "transitory," resulting mainly from supply chain and production disruptions brought on by Covid.

But what happens from here?

Already, stocks have declined 25-35%. This is a real bear market. Stocks can always drop further, but historically, buying after a 25% decline has often produced positive results over the following 12-18 months. It's never just one reason that causes this to happen. In fact, markets often begin to recover despite continued bad news. All it takes for stocks to recover is for sellers to become exhausted, and for opportunistic buyers to start stepping in. Things don't have to get better, they just have to start deteriorating at a slower pace.

It's possible that this process has already begun.

It's possible that inflation moderates, particularly in light of recession concerns. Inflation and recessions rarely go hand-in-hand, as inflation reflects excess demand and recessions reflect inadequate demand.

It's also possible that the strong dollar, cited above as a reason for pessimism, may actually relieve inflation by making imports cheaper. This would be good for US markets.

It's possible, too, that the Fed has already caused a recession, and will turn around and lower interest rates in the next 12 months.

It's possible that wage growth leads to more homebuyers and more construction activity.

It's possible that inflation will reduce the risks arising from excessive debt, resulting in a more stable economy, and higher enterprise values for stocks.

It's possible that technological innovation will put deflationary pressure on the economy, providing increased earnings growth and lower interest rates. This sort of thing happens in a million boring ways, but even small improvements add up.

It's possible that Russia eventually halts its invasion of Ukraine, even if withdrawal appears unlikely.

It's even possible that the midterm elections bring in a legislature that cuts spending and reduces inflationary pressures. Of course, out of everything I've said so far, this is the most far-fetched. What might be more realistic is that the conclusion of midterm elections may reduce some of the uncertainty facing markets, and provide an upward lift.

I don't know how, or when, the current bear market will resolve itself. I only know that, eventually, it will. Remember, things don't have to actually get better for the market recover. Instead, all we need is for things to be "less bad" than investors currently expect. As stocks continue falling, that hurdle just gets lower and lower.

What should I do with my money?

This is a hard question to answer in generalities. The best answer is to stick to your financial plan, or to get one made for you if you don't already have one. Especially for people entering retirement, it's important to make the right moves so that your portfolio can provide you with a lifetime of dependable income. These first few years of retirement are actually the riskiest of your entire life. But that's a subject for another article.

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