Welcome To A Bear Market – Expect Another 10% Down

Price crash and bear market

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Now We Know It’s A Bear

As of the close at 3749.63 on 6/13/2022, the S&P 500 confirmed that it has been in a bear market since the all-time highs on 1/3/2022. On that date, the S&P traded at 4796.56 and has fallen 21.8% since then.

In the past 105 years, there have been 24 bear markets as defined by 20% pullbacks from the prior high. This includes 4 instances where the market only hit the down 20% level on an intraday but not closing basis. Bear markets occur every 4-5 years on average, last a median of 420 days and have a median 34% decline.

Bull and Bear Market History

Author Spreadsheet

Regardless of these averages, we see there are basically 2 types of bear markets – large corrections and longer-term bears. Since 1980, it has been easy to tell the two types apart. The corrections drop quickly but are finished within a few months, catalyzed by a geopolitical event (1990 end of the Gulf War) or central bank action (Fed rate cuts in 1987, 1998, 2018, 2020, ECB support in 2011). In all but two of these cases, the correction ended down almost exactly on the 20% mark that defines bear market territory. The exceptions were the 1987 crash and 2020 COVID crash which were down about 34% each.

The longer-term bear markets lasted over 1 year and were caused by market imbalances too big or inappropriate to address with rate cuts (peak inflation in 1980-82, dotcom crash in 2000-02, and housing bubble collapse in 2007-09).

At this stage in the current bear market, it looks unlikely that we are in the large correction type. While the current magnitude and duration are similar to 2011, it’s very clear that the Fed is not about to lower rates anytime soon with inflation still raging. It’s possible peace could break out in Ukraine at any moment, but also rather unlikely given the determination of both sides to keep fighting.

If we are now in a longer-term bear, I would be surprised to see the ~50% pullbacks observed in 1973-74, 2000-02, and 2007-09. My simple valuation models predict about another 10% down from here, which would take the S&P 500 (SPX) to around 3400 or the SPDR index fund (SPY) to around 340. This would represent a decline of about 29% off the prior high, a similar decline to the inflation-busting bear market of 1980-82.

Another 10% Drop

One gauge I am using for this forecast is a simple earnings discount model. It is based on the formula for the present value of a growing perpetuity as shown below.

Present Value of a Growing Perpetuity Formula

financeformulas.net

In the case of the S&P 500 valuation model, D actually represents the earnings per share of the index, which can be found at the S&P website. My convention is to use the As Reported earnings for the four quarters ending with the current quarter. Many analysts and commentators refer to Operating Earnings, but I find As Reported earnings are more conservative and a better indicator of over and under valuation.

For the discount rate r, I use the current 10-year Treasury yield plus a risk premium of 5%. The 5% risk premium is in line with the long-term average, and I have found it to be useful in estimating over or under valuation. Alternatively, one could fix the S&P level at its current value and solve for the risk premium. In that case a risk premium under 5% would be overvalued and under 5% would be undervalued. My method, however, is to leave the risk premium at 5% and solve for the fair value of the S&P. For the expected long-term growth rate, I generally use 2.5% (in line with the long-term GDP growth) for the base case but look at higher and lower growth rates to see how they affect fair value.

An interesting side note is that the higher the base interest rate, the less the growth rate assumption affects the fair value. So mathematically, it is no surprise that growth stocks have been hit harder lately as higher interest rates make future growth less valuable today.

Putting it all together using current data, I get the following result:

S&P 500 Valuation Model

Author Spreadsheet

With a 10-year rate of 3.43% and risk premium of 5%, the discount rate is 8.43%. Factoring in the 2.5% growth rate expectation, the fair P/E for the S&P is 16.86. Multiplying by earnings of $200.02, the fair value of the S&P is 3373.

An even simpler method is to compare the S&P 500 level to its long-term trend line. I maintain a spreadsheet for this going back to 1950 which I update monthly. If plotted on a semi-log chart, the S&P fits a trend line with a high R squared value of 0.94.

S&P 500 History

Author Spreadsheet

At the end of 2021, the S&P was trading at 43.5% above its long-term trendline. This is the highest dislocation from the trend line since 1956 except for the dotcom bubble, where the index peaked at 106.1% over trend in March 2000. By the end of May 2022, some of the overvaluation had come out, but the index was still 20.8% above its trend line value of 3420.

Getting simpler still, I used the well-known technical analysis method called “drawing a straight line.” Seeking Alpha’s detailed charting tool is available for tickers like SPY but not the index. In any case, we see that the pre-COVID crash high from March 2020 as well as support levels from late 2020 before the index went on its huge run are around a SPY level of $333. The actual pre-COVID high for the S&P was 3386.

SPY chart

SPY Detailed Charting Tool (Seeking Alpha)

All these methods point to a target level of around 3400 for the S&P.

What If I’m Wrong?

It’s clear that the current bear market has already lasted longer in time than the correction-type bears like 1987, 1990, and 2020. The current bear would have to bottom very soon to look like any correction-type bear in recent history, the best comparison being 2011. As I stated above however, central banks are unlikely to provide the catalyst for a bottom anytime soon. On the off chance that I am being too pessimistic, and the market bottoms for some other reason like peace in Ukraine, then I would not want to be short in case that catalyst happened.

On the other hand, if I am being too optimistic, history suggests that holding is the best course of action for now even if the current bear market is destined to be lower and deeper. Looking at longer-term bear markets, there has typically been a sideways period in the second half of year 1 where the S&P is in a range of -10% to -20% off the prior highs. The biggest downdrafts typically come at the very end of long bear markets

Bear Market Drawdowns

Author Spreadsheet

Conclusion

Now that a bear market has been confirmed, it is more prudent to pause and assess valuations and historical patterns than to just sell everything. My valuation metrics put the fair value for the S&P about 10% lower around 3400. I am not a trader, so I will not be attempting to sell here and buy back 10% lower.

All I would recommend selling now are the bursting-bubble areas like meme stocks, high multiple tech, and crypto. Stocks of companies with good earnings and short-duration bonds of issuers with good credit should be held here. Historical bear market patterns indicate we could be in for several months of sideways action. This is a good opportunity to upgrade your portfolio quality and continue to watch for signs of either a bottom or a big downdraft that eventually ends the longer-term bear markets.

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