Bear markets happen for a lot of different reasons. They each differ in why stocks decline for an extended period. But when you break it down, they also have a lot in common…

There are four “phases” of a bear market that you need to be aware of:

  1. Initial Decline – This sets in after a big run higher in stocks. It catches most off guard.
  2. Relief Rally – This sets in motion a psychological state for most investors that phase 1, the initial decline, was just a correction, and the worst is behind us.
  3. Panic – This is the worst phase of the bear market. Every sector of the stock market suffers large declines.
  4. Bottom – This phase is marked with capitulation from most investors, extreme pessimism, and a general consensus that the future is bleak.

Then they shared examples… from the behavior of the Dow Jones Industrial Average in 1929… to the dot-com bust from 2000 to 2002… and the S&P 500’s 56% percent decline from 2007 to 2009 amid the financial crisis.

 

US Economy

 

  • The September jobs report was stronger than expected, delivering another confirmation that the labor market remains tight.
  • The unemployment rate dipped back to pre-COVID lows.
  • Tight financial conditions have taken a toll on financial assets but are yet to visibly impact the labor market.
  • Stocks tumbled on the payrolls upside surprise (which removes the hopes of a near-term “Fed pivot”).
  • The US dollar is rallying.

 

 

  • The 30-year Treasury yield is nearing 4%.

 

 

  • The inverted yield curve has been signaling a recession ahead.

 

 

  • The market expects the Fed to hike rates by 75 bps in November, 50 bps in December, and 25 bps in February.

 

 

  • Many consumers have been reporting difficulties paying bills.

 

 

  • The NFIB small business optimism index edged higher in September.
  • However, the stock market weakness this month will be a drag on the NFIB indicator, which tends to lag equity performance.
  • Inventory-to-sales ratios continue to climb as shortages ease
  • Nomura sees the September month-over-month CPI increase at 0.4%. Housing continues to dominate the US CPI.
  • Easing supply bottlenecks point to slowing core goods inflation.
  • But supply-driven improvements won’t be enough for the Fed to “pivot.” The central bank will want to see “convincing” evidence of falling underlying inflation.
  • Longer-term inflation expectations ticked higher with gasoline prices.
  • Rent inflation has been the highest in the “outer-ring” suburbs.

 

 

  • The Mortgage News Daily mortgage rate index is back above 7%.
  • Once again, the CPI report surprised to the upside, pointing to entrenched inflation in the US.
  • The core inflation climbed 0.6% in September, hitting a multi-decade high on a year-over-year basis.

 

 

  • Here is a quote from Nomura.

… today’s report supports our long-held view that inflation is much more entrenched than the market consensus and the Fed’s expectations. As a result, we believe today’s data supports our above-consensus terminal rate forecast of 5.25-5.50%, including our call for 75bp hikes in both November and December.

  • At 0.6% per month, the yearly core CPI is not moving down any time soon.

 

CPI Report

 

If inflation pressure is easing, it’s not evident in the September Consumer Price Index. Shelter costs are keeping core inflation high and likely ensuring several more rate hikes. RSM’s Joseph Brusuelas sent this sober breakdown of the numbers.

Key Points:

  • The September CPI rose 8.2% from a year ago, including a 0.4% gain in just the last month.
  • On a three-month average annualized basis, rent of primary residence surged 9.9% while owner’s equivalent rent rose 9.5%.
  • Food prices are up 11.2% in the last year. Medical care is up 6%.
  • Hopeful signs include falling shipping costs, retail inventory liquidation and easing commodity prices (except oil).
  • Investors should anticipate a 75 basis point rate hike in November and another 50 basis points in December.

Today’s CPI report suggests the Fed’s tightening strategy, which it considers aggressive, isn’t aggressive enough. Brusuelas thinks the new data narrows the window for a soft landing and recession should be next year’s baseline scenario.

 

Earnings Season

 

As of last Friday, the most recent update available from Birinyi Associates’ weekly P/E estimates update, the forward 12-month Wall Street consensus P/E ratio for the S&P 500 is 16.3. So, shares of the S&P 500 companies are trading at roughly 16 times future earnings – the share price is about 16 times greater than their earnings per share (“EPS”) for a given one-year period.

(For reference, this time last year, they were trading at 30.7 times earnings. That was really overvalued.)

Now, let’s look at the S&P 500’s current P/E ratio, which by convention accounts for the trailing 12 months of earnings. The index checks in at roughly 18 times earnings – also not too extreme, but a little higher than future expectations.

In other words, if things go the way Wall Street is expecting with earnings over the next six weeks, stock prices have a little further to fall. Otherwise, they wouldn’t align with forward P/E expectations of roughly 16 times earnings.

The difference between the S&P 500 trading at 18 times earnings today (around 3,600) and 16 times earnings (which would be 3,200 at current earnings) is about 10%.

In other words, the U.S. benchmark for stocks could easily fall 10% based only on current fundamentals.

The earnings part of the equation here is a moving target. What companies report over the next six weeks will matter a great deal.

If companies’ earnings generally come in below current expectations, stock prices could have even further to fall. That’s because if Wall Street expects less earnings, that would push up the market’s P/E multiple, making stocks even more overvalued relative to earnings unless prices fall.

In many market bottoms, the S&P 500 didn’t stop falling until the index’s 12-month forward P/E dropped to somewhere between 13 and 14. The S&P 500 bottomed with a P/E in that range at the end of the dot-com bust in 2002… and in the COVID-19 panic.

At today’s levels, if the S&P 500 dropped to a P/E of 13 or 14, its value would be between 2,600 and 2,800. That’s about 22% to 27% lower than today’s close for the U.S. benchmark.

Earnings season begins in just a few days. Those current expectations won’t matter for long.

 

The Fed

 

Guggenheim CIO Scott Minerd thinks recent interventions in Japan and the UK show how Fed policy increasingly threatens financial stability. He sees growing risk of an “accident” which could happen soon.

Key Points:

  • The Fed’s rapid rate hikes are exposing market fragilities. Interventions seem to have helped but haven’t addressed underlying structural causes.
  • Policymakers seem indifferent to the impact their hawkish rhetoric has on financial stability outside the US.
  • Since 2007 risk has migrated into shadow banks and other yet-to-be-discovered corners.
  • Rate hikes so far were relatively easy since they simply brought policy to neutral. Black swans are beginning to appear as policy enters more restrictive territory.
  • Market participants who once provided liquidity are facing their own margin calls and unable to help.
  • Fed officials can’t keep telling the world “We like what we see” when markets are convulsing.

Minerd concludes, “The end of Fed tightening will come when something breaks and the Fed will have no choice but to reliquefy the system, an event which I would expect before year end, and most likely before the end of the World Series.” That means by November 5, if the World Series goes to seven games. The next few weeks will be exciting if Minerd is right.

The September jobs report came out stronger than expected, suggesting even the Fed’s aggressive tightening isn’t cooling the job market much. Workers remain in high demand.

 

Market Data

 

  • Q3 (and Q4) earnings expectations have been downgraded sharply.

 

 

  • The Nasdaq drawdown is now the highest since the financial crisis, …

 

 

  • The Nasdaq Composite is testing support.

 

 

  • The Russell 2000 index is also at support.

 

 

Quote of the Week

 

“If you never want to be criticized, for goodness sakes, don’t do anything new.” – Jeff Bezos

 

Picture of the Week

 

 

 

 

All content is the opinion of Brian J. Decker