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A Growing Economy Can Be Mauled By a Bear Market

The risk of a bear market in stocks is greater than most believe. That’s because even a growing economy can be mauled by a bear market. Yet, this truth is buried under the drumbeat of declarations ruling out a recession — and therefore a bear market.

In the course of the recent stock-price correction, the economy’s apparent strength was repeatedly held up as a reason to shrug off market volatility. The basic argument is that there’s no sign of a recession — defined as a sustained contraction in economic activity — so a bear market couldn’t possibly be a concern.

But our analysis shows that a recession is neither a necessary nor a sufficient condition for a bear market, defined as around a drop in stock prices of 20% or more. Of the 14 post-World War II bear markets, nine were associated with recessions; but five occurred when economic growth was positive, but decelerating.

A 21st century example is the brutal 2002 bear market associated with the 2002-03 slowdown that ended without recession.

The post-World War II period also saw 14 periods of declining economic growth that included 21 stock-market corrections, during which equity prices fell at least about 10% without entering bear-market territory. While 17 of those corrections occurred around periods of decelerating economic growth, four were actually associated with full-blown recessions.

That brings us to Paul Samuelson’s famous quip, from half a century ago, that the stock market has predicted nine of the last five recessions. Most get a chuckle out of belittling recession risk, but while his precise figures may not have been accurate, he was right on the mark in term of substance. Indeed, the key implication of his statement — that many bear markets were not associated with recession — is widely overlooked, and it underscores the fact that a bear market is possible even without a recession in sight.

More often than not, bear markets are associated with recessions, and stock price corrections not amounting to bear markets are much more probable during non-recessionary periods of declining growth than during full-blown recessions.

But if investors are to have their eyes wide open, they should also know that more than one-third of bear markets have occurred without a looming recession. Conversely, nearly a quarter of recessions weren’t associated with a bear market.

In fact, there’s a practically one-to-one correspondence between stock price corrections and declining economic growth that’s held over many decades — even during the unprecedented quantitative easing following the last recession. Since 2010 there have been three full-blown cyclical downturns in economic growth, associated with at least four double-digit stock price corrections. Early this year stock prices had a 10% correction, and this fall we’ve already seen a similar drop.

Indeed, the Dow Jones Industrial Average DJIA, -1.49%   had plunged 13.1% from its 2018 closing high through Wednesday, including a 8.7% drop just in December. The S&P 500 index SPX, -1.54%   has skidded 14.5% from its 2018 closing high, including 9.2% this month.

A key point is that these corrections all occurred when economic growth was easing, as it is today.

Decision-making under unavoidable uncertainty defines the job of an investor, business manager or policy maker. But the risk of a downturn in economic growth – which waxes and wanes – is actually knowable.

When the yield spread — the difference between the yields on 10-year and 2-year Treasurys — goes negative, it’s widely believed to be a harbinger of an upcoming recession. But as it’s hovering around its lowest reading since 2007, Wall Street pundits seem keen to explain why this time, it’s different, there’s no recession in sight, and therefore no danger of a bear market in stocks. According to their view, investors should go ahead and buy the dip.

But even if we assume there’s no recession imminent, a declining yield spread is a reliable signal of slowing growth, and that brings with it the heightened risk of market corrections.

Unfortunately, from our cyclical perspective, the end of the current deceleration is not yet in sight. For example, Weekly Leading Index growth, which leads peaks and troughs in overall economic growth by a couple of quarters, remains in a downtrend, pointing to further economic slowing ahead.

Therefore, not only does the heightened risk of stock price corrections remain in force but also a full-blown bear market can’t be ruled out. Prudence dictates that investors should take this into account when deciding whether to buy on dips or reduce their exposure to equities in these choppy markets.

Only when a renewed acceleration in economic growth takes shape will the risk of stock price corrections — and certainly bear markets — drop drastically.


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