Is the bear market predicting recession?
Not all bear markets have recessions. When they do, the bear market typically starts two months before a recession begins and typically ends four months before the recession ends. That makes sense, given that the market is always trying to discount the future. Something to keep in mind as we will start reading more and more about a recession in the coming weeks.
In my view, the key is to differentiate between a technical recession (i.e., a few quarters of negative growth followed by a return to trend growth), an inventory cycle (the classic recession scenario in which tight monetary policy driven by inflation triggers a recession just as companies spent too much on capital equipment), and a financial crisis (the above plus large financial imbalances that come unglued during the downturn).
Given that COVID-19 is presumably a temporary demand shock, I am assuming that if we get a recession it will be of the technical variety. But it will be important to watch the jobless claims data to make sure that the economy doesn't enter a negative feedback loop of layoffs begetting more layoffs. A robust fiscal response combined with ample liquidity from the Fed will hopefully be able to prevent this from happening.
It's important to remember that every recession is different, as this one will be, should it happen. And not every recession is a financial crisis. The global financial crisis in 2008 was a perfect storm with financial contagion spreading to all corners of the market. The current episode certainly has some of the contagion aspects now that an oil shock has been added to the mix, but the overall degree of leverage in the system seems far less today than 2008. Households are clean, the banks are clean, and most of the leverage in the corporate sector seems to be on the financial engineering side (for acquisitions and share repurchases) as opposed to old-fashioned capital expenditures.
Another important angle to consider when thinking about recessions is that the response function of the Fed and the trend in interest rates and inflation is also important. For example, the 1974 recession produced a 48% bear market in part because the Fed kept on raising rates throughout the entirety of that bear market. Only when it stopped in October 1974 was the market able to recover. It's a far cry from today's situation.
The power of diversification
For most long-term investors who have a properly diversified portfolio, the market storm has been scary but manageable, at least so far. A 60/40 stock/bond portfolio since the valuation peak in January 2018 is still up 5%, even though the drawdown in the S&P 500 from the February high is 27%. This is why it's important to (a) have an all-weather portfolio that is appropriate for an investor's financial situation, risk tolerance, and liquidity horizon (i.e., when the investor needs to draw from it), and (b) sticking with that plan through thick and thin, and (c), rebalance from time to time. At some point, that last one should be the next step for many investors.
For now, as we wait for COVID-19 to peak, for earnings season to kick in, for the policy response to take shape, for the contagion across asset classes to abate, and for the margin calls to be fulfilled, I think it's safe to say that we will see plenty more volatility across all markets. But technically, the market is very oversold now, and hopefully, we reached levels last week from which we can start building a base.
Typically, the market will form a momentum low, followed by many weeks or even months of base building, followed by a retest of sorts, and then finally a new bull market. So, even if last week was the low (unknowable for now), it will take time for the market to regain its health.
So, in the days ahead, stay safe. If you have a plan that's right for you, stick with it. Selling now means locking in losses. If you don't have a plan or are wondering if yours is still right for you, talk to a financial professional. In life and finances, now is a good time to hunker down.