Bear Markets, Liquidity And How Low Stocks Can Go

Summary

• People are pointing to the current correction, about to be a "bear market," as some rare thing. Is it really?
• Is the stock market correction a harbinger of anything terrible in the economy or a predictable reaction to lower liquidity?
• In my forecast for 2022, I said to expect a year a lot like 2018. I'll stick with that, but there's a chance for a great H2 as well.
• Our targets are lower than consensus, but when charted out, actually look quite normal.
• Play defense by selling the mini-rallies and eventually buy secular growth stocks while the bear market plays out.
• This idea was discussed in more depth with members of my private investing community, Margin of Safety Investing. Learn More »

DNY59/E+ via Getty Images

In my recent article S&P 500: Historic Overvaluation Is Tinder Under Stock Market, I pointed out that a reversion to the trend growth of the S&P 500 would necessitate a significant correction.

That correction is playing out and about to become a bear market. It's consistent with what I suggested in my 2022 Outlook that we this year would largely resemble 2018.

Today I want to quickly discuss what we know about bear markets, how low this one can go and what investors should be doing about it.

Corrections Usually Happen Fast

The speed of corrections of 10% or greater usually happen fairly quickly. Hence, the term "elevator drop." Here's a look at corrections so far this century, based on market research by Avi Gilburt here.

• February of 2001: Equity markets declined of 22% within seven weeks;
• September of 2001: Equity markets declined 17% within three weeks;
• July of 2002: Equity markets declined 22% within three weeks;
• September of 2008: Equity markets declined 12% within one week;
• October of 2008: Equity markets declined 30% within two weeks;
• November of 2008: Equity markets declined 25% within three weeks;
• February of 2009: Equity markets declined 23% within three weeks.
• May of 2010: Equity markets experienced a "Flash Crash." Specifically, the market started out the day down over 30 points in the S&P500 and proceeded to lose another 70 points within minutes. That is a loss of 9% in one day, but the market did manage to close down only 3.1% in one day!
• July of 2011: Equity markets declined 18% within two weeks
• August 2015: Equity markets decline 11% within one week
• January 2016: Equity markets decline 13% within three weeks
• January 2018: Equity market decline 16% within three weeks
• October 2018: Equity market decline 12% within three weeks
• December 2018: Equity market declines 13% within 3 weeks
• March 2020: Equity market declines 34% within 5 weeks.

Within the context of bear markets, we can see that the biggest down periods, which are also the scariest, happen relatively quickly. I believe we are seeing a scary correction right now to kick off this bear market.

At some point soon, we will see a rally within the bear market. That rally will be a fraction of the correction. These are known as bear market rallies and are a great time to sell certain investments you missed selling ahead of time like I suggested to from my Q4 Outlook and Game Plan to my 2022 outlook.

Typically, bear market rallies retrace about half of what was lost. That is, if the market falls 20%, we would expect a rally approaching around 10%. In my opinion, we could come up short of that or overshoot it a bit depending on the niceties of one Chairman Powell.

Bear Markets Take Longer

I think that this chart by LPL is remarkably helpful. What you will see below are the average length of bear markets. Note the with and without a recession averages.

Bear Markets Since 1956

LPL

At this point, I do not expect a recession anytime soon, though I do think much of the economy will miss optimistic expectations.

My short answer on how long this bear market will last is until sometime this year. Again, I reference 2018.

Liquidity And Stock Prices

I know people like magical voodoo charts that perfectly predict the markets. It can't be done. All we can do is break down scenarios that are more and less likely. Anyone who tells you different is a pulling your wallet.

There are a lot of factors that will go into determining how low the stock market can go. I have found that market liquidity is the quant factor that impacts financial asset markets the most important in my 25 year career.

Liquidity drives the demand for everything from products to financial assets. This is just Econ 101 stuff, but widely ignored.

While many want to say that the stock market is driven by sentiment, and I do believe that's largely true, changes in liquidity generally lead changes in sentiment.

One way to put that would be "liquidity speaks, sentiment listens."

The Federal Reserve is the most important player in determining liquidity. This is where the phrase "don't fight the Fed" comes from.

Here's Guggenheim's representation of liquidity's impact on stock prices:

Liquidity & Stocks

Guggenheim

While there can be short-term time delays between the impact of liquidity on asset prices, it's not generally very long before prices react to changes in liquidity.

With the Fed tightening, it's normal to expect excessive valuations to contract. The questions are how fast and how much?

The how fast, or when, question is what people want to know most. It shouldn't be. Overvalued is overvalued and eventually that always contracts.

Trying to be a "just in time" seller is extremely difficult. Better to start selling incrementally a bit early, miss some upside and buy back at a lower levels incrementally. Patient investors who manage risk first understand this.

The how much question is a bit easier actually. When tied to liquidity we can estimate where prices will go under various scenarios. I see three most likely scenarios:

• The Fed is more aggressive than the markets think they will be.
• The Fed is less aggressive than the market thing they will be.
• The Fed has to react to a black swan event, much like they had to react to the COVID crash.

If the Fed gets too tight, whether on purpose to quell inflation, or because they make a mistake, then the stock market can go below fair value which I peg at around 3000 (which I have discussed elsewhere).

If the Fed is less aggressive than expected, then stocks can find a "higher bottom" and then start to rebuild to new highs sooner.

The "black swan" response is the hardest to prepare for as by definition we don't know what a black swan would be ahead of time. The ones on the radar are a Russia/Ukraine war, Middle East war or a China financial collapse tied to real estate.

By virtue of being "on the radar" though, we can surmise those things are largely already priced into a somewhat efficient market. What's not priced in is likely the potential for things to get worse than expected.

Further, how would the Fed respond to an event? Would they flood the world with money again or take a more measured approach? There's no way to know, but I do think of the 2014-16 market consolidation as a base of extremely firm support for the stock market. I'd have a hard time believing the Fed firehouse didn't come out if stocks approached those levels.

Our S&P 500 Scenarios

I maintain this chart ongoing. There are three prices that I'm seeing as at least somewhat likely in a bear market.

• Middle 3000s on the S&P 500 which represents a normal pullback.
• Very upper 200s on the S&P 500 which represents a severe pullback.
• Around 2000 on the S&P 500 which would be the "Armageddon" scenario.

2022 Bear Market

Margin Of Safety Investing

My anticipation, based on valuations and that I do not believe the Federal Reserve makes a mistake on tightening too much, is that an S&P 500 (SPY) (VOO) heads to the middle 3000s sometime this year.

It won't take much to push the S&P 500 to the very upper 2000s though if the Fed has to maintain a tightening posture past summer due to inflation. I think that inflation start, to moderate by Q3, but that's still an unknown. We will have to wait and see in real time what's happening come the midyear Fed meetings.

The scary broadening pattern on the chart is in play as well. It's not outside the realm of possibility that if the Fed makes a mistake or there's some black swan (being the most likely in my opinion), we see the S&P 500 around 2000 again. Again, it will be important to monitor things in real time.

My technical analyst, who uses Elliott Wave analysis combined with several proprietary methods, shows a very similar set of potential outcomes as my mixed technical and quant analysis:

2022 Crash Analysis

Margin Of Safety Investing

He sees major support in the middle 3000s on the S&P 500 as I do, again in the upper 2000s and then in the lower 2000s. For what it's worth, when we roughly agree, that has been pretty powerful.

What Investors Should Do

The thing not to do is panic sell on down days. If you have trimming that still needs to get done, do it on relief rallies. And, when you do it, get to where you want to get to within a few days. That is, sell big, sell fast.

What you want to sell are investments that do not have secular tailwinds.

2020s Investment Barbell

Margin Of Safety Investing

Our four-step process borrowed from a pair of multi-billion dollar hedge fund operations starts with analyzing secular trends and staying on the right side of those powerful forces. Our 2020s Investment Barbell sets out our broad strokes on where we want to invest.

As we come out of the bear market, you want your portfolio to be over weighted on the left side of the barbell if you are a long-term growth investor. An 80/20 split is what I'm targeting for growth clients.

If you are a retiree, then a split of 60/40 is likely more appropriate. While that will not grow as much, it will provide more income and diversification that should quell volatility a bit.

A concept that I'm introducing in a separate article is the concept of a "great divergence" in stocks coming the rest of this decade.

The simplified version is that there are well around 150 to 200 stocks on the S&P 500 that are zombies or at least sluggish. They're marked by secular stagnation in their businesses and second best or worse financials. These stocks will be replaced on the index by faster growers with secular tailwinds and stronger financial circumstances (from balance sheets to scalability and margins).

Ultimately, you want to upgrade your portfolio to what are likely to be secular winners the rest of this decade. That means not only large-cap investing, but a large swath of mid cap investing into companies that will be on the S&P 500 at some point this decade and receiving the passive inflows from fund investors.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.