The Factory Daily Letter

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Having fallen more than 20% from its high, the S&P500 is now technically in a bear market

How might what's gone before inform us on what may now be up ahead?

Having fallen 20% from its January top, the S&P500 index has now followed the Nasdaq 100 (which has been in one since February) into a bear market. It also means that any uptick from here will be technically referred to as a ‘bear market rally’. 

The bear markets the US equity market has suffered since its inception have all had their different characteristics: some accompanied by periods of economic recession; some triggered by more idiosyncratic factors (the Covid crash being the obvious recent example). They also clearly vary in terms of depth and length. The chart below provides a neat historical overview of the magnitude and duration of bull and bear markets for the S&P500 since the index’s inception in the 1940s:

Source: FactSet; Pictet Trading Strategy; as of 15/6/2022.

Markets were slow to recover their losses after the bear markets of the dot-com bubble (2000) and the GFC (2007)

This is the fourth bear market since 2000. While the Covid bear market remains atypical in terms of speed and recovery, the other two (the dot-com bubble and the GFC) were also outliers in so far as they were more protracted and challenging than most – and moreover featured a number of bear market rallies that taunted - and ultimately misled - investors.

The GFC bear market played out as a 58% drawdown over 352 days, but it took more than 1,000 days for the index to recover to its former peak. In 2000, the bear market that occurred when the dot-com bubble burst saw the S&P500 drop 51% over 638 days, and it took 1,165 days for it to regain its former high: 

Source: FactSet; Pictet Trading Strategy; as of 15/6/2022.

The extent of this bear market could hinge on the likelihood of recession

Our PTS bear market probability model is an aggregate measure of various macro and market indicators within which each component is ranked with reference to its historical range (using percentiles). A higher reading signals a higher probability of a bear market unfolding over the medium term, with readings of 70% or above having historically tended to precede bear markets - successfully flagging those of 1980, 1987, 1998, 2000, 2008, 2020 - and now that of June 2022.

In terms of timing, the indicator has usually tended to fall from a peak of above 70% before a bear market has unfolded – as is illustrated below.  Over recent weeks the indicator has reached its highest level ever around 90% (clearly far above the 70% threshold) and from where it had also already started to fall:

Source: FactSet; Pictet Trading Strategy; as of 15/6/2022.

The macro momentum is losing traction

Bear markets have typically tended to unfold when the economic situation has been rapidly deteriorating. For now, most leading indicators in the US remain positively-oriented (despite the rising-yield environment and Russia’s invasion of Ukraine). However, our PTS macro momentum model (which is based on 10 leading indicators focusing on the housing market, job market, inflation, heavy truck sales, the trend in the S&P500, the ISM and the yield curve) is now showing signs of deterioration: as illustrated below, the indicator has now fallen from nearly 0.9 in February to 0.6 as we write:

Historically the indicator has always suffered a strong reversal before a recession has occurred (apart from the Covid recession in 2022 which was of course triggered by the idiosyncratic, pandemic event). A reading of 0.4 has historically proven the key ‘recession warning’ level and the indicator is clearly now heading in this direction. Given the level of uncertainty and lack of catalysts currently evident in the global economy – not to mention the headwinds presented by hawkish central banks that have now embarked on policy tightening - we think it unlikely that we will see a rebound across the necessary economic drivers that is sufficient to support a significant uptick the macro momentum in the short-term.

Source: FactSet; Pictet Trading Strategy; as of 15/6/2022.

The number of economists predicting recession is rising

The chart below illustrates how the probability awarded by economists surveyed by Bloomberg of recession over the next 12 months has been evolving since the beginning of 2021. It has now reached 30%:

Source: Bloomberg Finance L.P; Pictet Trading Strategy; as of 15/6/2022.

So what can history teach us about past bear markets?

Most of the time, a bear market indicates that recession is imminent. Of the 12 bear markets suffered by the S&P500 since 1945, in 8 instances a recession has followed within 12 months of the market first falling into bear market territory.

Source: FactSet; Pictet Trading Strategy; as of 15/6/2022.

What can we extrapolate from the data? Firstly, the fact of whether or not a recession has followed the market’s entry into a bear market has historically proven significant vis-a-vis the depth and length of the bear market. Those bear markets that have preceded recessions have posted an average drawdown of -36.7%, and have taken an average 16.8 months to bottom and 27.6 months to make a new high. These figures fall to -28%, 7.3 months and 19.4 months respectively across those instances when no recession has occurred within 12 months of the index first entering a bear market. Of note, this year it has taken the market just 5.3 months for the market to cross the -20% peak-bear-market threshold, much faster than the median and average times (9.2 and 9.8 months respectively). On a median basis, it has taken an additional 2.7 months for bear markets to reach local bottoms.

While the sample is tight, it seems that the more rapid selloffs usually lead to shallower bear markets, which are quicker to find a local bottom. The stats are highlighted in the tables above and below.

Source: FactSet; Pictet Trading Strategy; as of 15/6/2022.

Clearly no two bear markets are the same in nature, duration or magnitude, nor in terms of what triggers them. However, in our efforts to find a pattern we refer to the average performance of the index across past bear markets, and illustrate below how on this basis a local bottom tends to form shortly after index first technically enters a bear market (-20% from top).

Source: FactSet; Pictet Trading Strategy; as of 15/6/2022.
Source: FactSet; Pictet Trading Strategy; as of 15/6/2022.

A long decline in several phases

It is worth noting that the more recent bear markets of 2000 and 2007 were particularly long. Nonetheless, the chart below shows the historical average performance of the index once it has entered a bear market in the past. As implied above, the first low point seems to be reached just as the index reaches -20%, after which the first bear market rally tends to occur.

Thereafter the recurrent pattern is one of a second wave of declines – this time of greater amplitude and longer duration and sending the market to new lows.

It has been only after 130 days on average that a bottoming process has begun:

Source: FactSet; Pictet Trading Strategy; as of 15/6/2022.

So how does this current market differ?

What is remarkable about this instance is how the number of stocks that are already in a bear market already exceeds 60%. This suggests that a significant portion of the move has already been made - and in turn that it may indeed be too late to be too pessimistic in the near term.  Moreover, if we compare the current statistics (red) with how they evolved in the protracted bear markets of 2000 (blue) and 2007 (grey) – we notice how in this instance the breadth gauge has already risen to the 60% threshold: In 2007 and 2000, it took between 145 and 190 days to do so.

Not only does this distinguish the current from those particular bear markets, but the fact that a larger percentage of stocks are already oversold also signals potentially fertile ground for a bear market rally:

Source: FactSet; Pictet Trading Strategy; as of 15/6/2022.

The market could enter a stabilization phase

We have also taken a look at the most 20 most closely correlated historical periods in terms of market trajectory to that which has played out over the past 100 days (bear market or not). Unsurprisingly, 5 out of the 9 most correlated periods were during bear markets (1957, 1966,1970 1981, 2000). But of note, apart from 2000, they have been periods which have shortly proceeded the end of the negative momentum. We also note a strong tendency for the market to bounce after day 100: The median performance across the 20 “most correlated” periods (as highlighted in red) shows the market tends to take a break from its downward trajectory between days 100 and 140:

 

Source: FactSet; Pictet Trading Strategy; as of 15/6/2022.

The current environment remains challenging, and the lack of positive catalysts encourages us, as others, to be cautious in the near term. Nonetheless, several signs have been emerging that a worst-case scenario may already be priced to a significant degree – as is illustrated by the high percentage of stocks in the index that are already in bear market. Moreover, and while we are mindful of the distinct nature and characteristic of each bear market, the tendency for bear market rallies to occur right at the outset could call for a bear-market rally over the coming days (before – should the historical trend be taken up - a second leg of decline pushes the indices to new lows).

So it is that the ground could be fertile for a rebound in the coming weeks. But the recent price action has taught us that bullish phases remain fragile.

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