Yogi Berra famously said, "It's tough to make predictions, especially about the future." Of course, we still do our best to predict future outcomes of just about anything – especially stock prices. These days everyone is searching for clues as to what's next for stocks. With all the news of war, inflation, volatility, and rising interest rates, it feels like a bear market must be right around the corner.
Is a bear market probable? As investors, we deal strictly in probabilities to measure the balance between risk and reward. If the reward appears justified for the risk of our hard-earned capital, we invest. If it doesn't, we avoid it. There are no certainties when investing, just opportunities or avoidance. The great thing is that you can still make a lot of money even if you are wrong half the time. If you are right 60% of the time, you can make a killing. Even better is that your probabilities for success increase substantially the more time you allow for it. I know this because every stock market correction and bear market eventually led to higher highs given enough time.
What is a bear market? We adhere to the classic definition of a bear market - a peak-to-trough closing price decline of at least 20%. This type of decline differs from a "correction," which happens much more frequently, is typically short-lived, and is more about the ebb and flow of stocks rather than the economy's health. On the other hand, bear markets are nasty, gut-wrenching stock market pullbacks that can cause despair to even the most stoic investors. Most bear markets had stock prices drop by around 35%, give or take. A couple dropped about 50%. Ouch. The stock market corrected between 10- 19% around twenty-eight times in the last fifty years. There have also been nine bear markets, including the 34% bear market that Covid-19 stirred in 2020. That bear market lasted a little over a month, while some have lasted almost two years. Avoiding a bear market is one of those outlier moments that can put an investor or investment firm on the map. Even if you were just lucky with your timing, you would have had lifetime bragging rights and an opportunity to significantly outperform your benchmarks. Of course, you would also have the guts to buy back in after watching stock prices fall dramatically. That's not easy either, but nobody said investing was easy.
What is the best way to predict a bear market? It turns out that it is not about tracking stock price movements or even stock price valuations. Hundreds of "technical indicators" track the activity of stock prices available for you to utilize, subscribe to, or purchase as an investor. They may include Elliott waves, bollinger bands, triangles, channels, moving averages, or even the great mathematician Fibonacci. Most appear to be more of a coincident indicator rather than a leading one. And for those who point to high P/E multiples as a predictor of bear markets would have to explain how some bear markets occurred when valuations were comfortably below their long-run averages. And they would also have to explain why some bull markets lasted for years even at vastly elevated stock multiples. No, if you want to predict a bear market, the best way is to predict when the next economic recession will occur. The reason: Equity bear markets reliably coincide with recessions. According to Forbes, "A recession is a significant decline in economic activity that lasts for months or even years. Experts declare a recession when a nation's economy experiences negative gross domestic product (GDP), rising levels of unemployment, falling retail sales, and contracting measures of income and manufacturing for an extended period of time." Since the late 1960s, only one bear market has occurred without a recession - October 1987's Black Monday bear market. The Dow Jones Industrial Average (DJIA) dropped 22.6 percent in a single day, a loss that remains the most significant one-day stock market decline in history. No one could have predicted that, and since the index fell over 20%, it was considered a bear.
Are we forecasting a recession this year? The short answer is NO. The economic indicators that we rely upon are not yet signaling a high probability for an economic contraction within the next 6-12 months. Despite the challenges mentioned at the beginning of this article, the numbers point to a persevering economy. The latest numbers show GDP recently grew at an annual rate of 6.9%, and personal income levels, personal wealth, retail sales, and manufacturing are up. Unemployment, inventory of houses for sale, and interest rates are all low.
For these reasons, we continue to advise our clients to stay fully invested and overweight stocks, accepting the recent volatility as a short-term correction. We are mindful of potential game-changers that can occur, such as a severe escalation in the Russia/Ukraine situation or a drastic change by the Fed to an ultra-aggressive policy. But these are relatively low probability events, so we do not expect that investors will have to de-risk their portfolios for the time being. However, if the facts change, then so shall our advice.
Next month, I will review which combination of recession indicators Ranch Cap utilizes. Stay tuned.