Investors are worried about stocks being in a bear market, the economy heading into a recession, and the financial system perhaps leaning toward crisis. What is going on?
The first thing to understand is that you can have a bear market without a recession, and you can have a bear market or recession without a financial crisis. Recessions, however, have historically been accompanied by a bear market.*
So what is the likelihood of these three over the next six months?
First, how about a bear market? The short answer is we are likely in one already and that the big indexes such as the Dow Jones Industrial Average and the S&P 500 will likely soon join in. Commodities and natural resource equities are down well over 40% from their peaks in 2014. Emerging markets are down over 25% from their peaks. Many foreign countries, including China, Japan, and European, are down over 20% from their peaks. In the US, the Dow Jones Transportation Average is down over 25% from its peak and the Russell 2000 Index of Small Company stocks is down over 20% from its peak back in June of 2015. And if we measure all US stocks, about 50% are down over 20%. Therefore, it is most likely just a matter of time before the big averages join in.**
Second, how about a recession? Manufacturing as measured by the Institute for Supply Management (ISM) Index has contracted for four consecutive months, while the service sector has decelerated during the same period, although it is still showing growth. Many other indicators that are indicative of a weakening or recessionary economy are also trending down. That being said, this still could be a late cycle slowdown instead of a recession. I would put the odds of a recession in the next six months at 50%. One reason this is important for investors is that stock market declines tend to be deeper and more vicious within a recession.
Finally, how about a financial crisis? While there are signs of stress in the high yield bond sector, especially in energy related assets, other risk indicators for a financial crisis remain muted. I will say they have risen in the past month—especially for European banks, but are still relatively calm overall. One note of caution is that not only can these indicators change rather quickly, but also the next financial crisis will likely come from a direction few are expecting.
So, my bottom line is this: we are likely in or rapidly heading into a bear market for US stocks. This may be made much worse if a recession develops which I think is a coin toss. The bright news is that we don’t seem to have a financial crisis on our hands… yet.
What can an investor do? Check your strategy and your stock exposure. If what we have experienced is the first leg of a bear market, the last best chance to adjust your allocation is likely now. Consult with your wealth manager.