A Painful Bear Market

There is no doubt about it: we are in the midst of a bear market. But when you invest in stocks, bear markets are part of the terrain. Since 1947, there have been 15 bear markets. That works out to one bear market every five years. So, bear markets are bound to come, but when they arrive, it is discouraging and painful — even agonizing.

How is a bear market defined? The most common definition is when a key stock market index drops 20% or more. On January 4, 2022, the S&P 500 closed at an all-time high of 4,794, and on September 30 of this year, it closed at 3,586 — a decline of -25.2%. The tech-laden NASDAQ composite was down -32.5% for the first three quarters of 2022.

Since 1968, there have been eight bear markets, including the current one. How long do they last? The previous seven bear markets have averaged around 14 months, and we are already more than nine months into this one. But averages often do not tell the whole story. The shortest of these bear markets was triggered by the COVID-19 pandemic in 2020 and lasted a little more than a month. The bear market with the longest duration since 1968 was in 2000-2002, following the “internet bubble,” which lasted 31 months. The chart below shows the decline in the current bear market compared with the earlier seven:

During the worst of the 2020-2021 COVID pandemic, the Federal Reserve Bank expanded the money supply (M2) by an amazing 40%, and the Trump and Biden administrations engineered an enormous $6 trillion fiscal stimulus (all of the money borrowed). This fiscal stimulus, combined with rock-bottom interest rates, encouraged retail investors with bulging bank accounts working remotely, to indulge in rampant speculation. This led to the perfect storm for a bubble in the stock market’s favorite stocks. In previous investment commentaries, we analyzed the appearance of meme stocks and the wild gambling that propelled these stocks to absurd heights. But stocks of many companies with what appeared to be excellent prospects and business models also soared to extraordinary heights during this period. Below is a chart of the stocks of 11 of these companies which lost between 80 and 95% of their value from their peak through the end of the third quarter:

As can be seen from the chart above, stocks of some companies positioned to profit from the stay-at-home behavior of a large percentage of the American population reached ridiculous prices. For example, Zoom Video peaked at $537 a share in 2020; its P/E ratio on forward earnings was 166. The Peloton exercise craze encouraged speculators to bid up the stock to $166 per share, translating to a market capitalization of over $50 billion, but the company never managed to turn a profit. Peloton stock trades at $8 currently. The stocks of soundly profitable e-commerce companies like Shopify also reached ludicrous heights. Shopify had a P/E of 440 at one point. And fashionable green energy companies like FuelCell Energy also engendered similar speculative behavior. During the past 20 years, FuelCell Energy has never turned in a profitable year, but in early 2021 at its recent peak, it sold at 140 times sales with a market capitalization of $11.4 billion. In certain ways, the valuations of these stocks, and others like it, remind one of the “internet bubble” which led to the 2000-2002 savage bear market, when the NASDAQ Composite was down 78% from peak to trough.

The stocks of a considerable number of leading companies have not proven immune to the bear market. The FAANG stocks (Facebook, Amazon, Apple, Netflix and Google) and Microsoft led the stock market up in the great secular bull market which ran from March 2009 through December 31, 2021. At the close of last year, these stocks represented 23.5% of the market weighting of the S&P 500 Index. And their valuations had expanded dramatically as the bull market advanced. At the low end, the P/Es of Google (Alphabet) and Facebook (Meta) at year-end 2021 were approximately 25, while Amazon and Netflix sported P/Es in excess of 50. The stocks of two bellwether companies, Microsoft and Apple, had P/Es of 37 and 32 respectively at this time. Accordingly, as the Federal Reserve attempted to bring the soaring inflation under control through the medicine of ever higher interest rates, investors experienced a nasty compression in stock market valuations, which included these leading stocks as well as others in the chart below. To be clear, these quality growth companies have excellent business models, strong balance sheets and robust cash flow, and at BFS we continue to own many of these stocks in client portfolios. The chart below highlights the extent to which even the stocks of these leading companies have been punished as well:

We are constantly inundated by bad news these days. Turning on any TV news show is depressing, and investor psychology is one of the key components of stock market behavior. Here is just a short catalog of bad news geopolitically: the Russia/Ukraine war, with Putin threatening the use of tactical nuclear weapons; China’s continual aggressive behavior toward Taiwan; Iran’s push for nuclear weapons; the Chinese lockdown caused by COVID; and the likelihood of a cold and dismal European winter. Domestically, past monetary and fiscal excesses have led to robust demand chasing too little supply. This is a recipe for longer-lasting inflation, which will likely lead the Federal Reserve to raise interest rates well into 2023. This heightens the chances of a recession in the U.S., and also globally, in 2023. At BFS, we believe the possibility of a recession next year is greater than 50%.

So, given this backdrop, what is the likely path of the stock market over the next six to nine months? At the start of 2022, the S&P 500 was trading at a P/E of approximately 22. Currently, the P/E is roughly 16.8 — a compression in the overall stock market’s valuation of -24%. Meanwhile, many analysts project the growth of 2022 earnings for the S&P 500 to be roughly 7% — from $206 to $221. Although these analysts continue to predict that 2023 S&P 500 earnings will rise to $240, a recession next year could well reduce S&P 500 earnings by as much as 30% (the historical average for a U.S. recession) to $170. What stock market multiple should be applied to these earnings? If the Federal Reserve is successful in reducing inflation to below 4%, the P/E over the past 70 years at this level of inflation has been approximately 17. Inflation of 4-6% has carried a P/E ratio of 15.1. The table below shows where the S&P 500 might trade next year under various scenarios. With the S&P 500 currently trading around 3600, most of the scenarios below indicate that inflation at more than 4%, combined with lower earnings caused by a recession, would result in a continuing decline in the stock market:

As the table above indicates, it is likely that there is more pain to come — perhaps as much as 20% or more. The Federal Reserve’s need to continue raising interest rates to curb inflation will quite possibly not only cause a mild recession, bringing earnings lower, but also induce more compression in stock market valuations. Two final points: First, market bottoms are notoriously difficult to predict and we do not claim that we have a crystal ball. But we do believe that a thoughtful defensive posture currently makes sense for most investors. Secondly, bear markets do come to an end, and there is a rainbow at the end of a bear market. For that is when investors can find great stocks at a discount. So, we encourage investors to emulate the great money manager Peter Lynch, who invariably became more and more enthusiastic as bear markets deepened because of the great bargains available. Wealth is created by seeing the stock market as a marathon, not a sprint. This is the time for patience and perseverance.