Hashtags about a stock market crash may be trending on Twitter, but the selloff that has sent U.S. stocks into a bear market has been relatively orderly, market experts say. But it is likely to become more volatile – and painful – before the market stabilizes.
It was indeed a white knuckle ride for investors on Friday as the Dow Jones Industrial Average DJIA,
plunged more than 800 points and the S&P 500 index SPX,
traded below the 2022 closing level from mid-June before trimming losses ahead of the clock. The Dow sank to its lowest close since November 2020, leaving it on the brink of joining the S&P 500 in a bear market.
Why is the stock market falling?
Rising interest rates are the main reason. The Federal Reserve is raising its benchmark interest rate in historically large increments — and plans to keep raising them — as it tries to pull inflation back to its 2% target. As a result, government interest rates have risen. This means that investors can earn more than before by parking money in government paper, and increase the opportunity cost of investing in riskier assets such as shares, corporate bonds, commodities or real estate.
Historically low interest rates and ample liquidity provided by the Fed and other central banks in the wake of the 2008 financial crisis and the 2020 pandemic helped drive demand for riskier assets such as stocks.
That unwinding is part of the reason the selloff, which isn̵[ads1]7;t limited to stocks, feels so sharp, said Michael Arone, investment strategist for the SPDR business at State Street Global Advisors.
“They’ve been struggling with the idea that stocks are down, bonds are down, real estate is starting to suffer. From my point of view, it’s the fact that interest rates are rising so quickly, resulting in slowdown across the board and volatility across the board,” he said in a telephone interview.
How bad is it?
The S&P 500 ended Friday down 23% from its record close of 4,796.56 hit on January 3 of this year.
It’s a fierce withdrawal, but it’s not out of the ordinary. In fact, it’s not even as bad as the typical bear market. Analysts at Wells Fargo studied 11 previous S&P 500 bear markets since World War II and found that the downturns lasted an average of 16 months and produced a negative 35.1% bear market return.
A decline of 20% or more (a widely used definition of a bear market) has occurred in 9 of the 42 years going back to 1980, or about once every five years, Brad McMillan, chief investment officer of the Commonwealth Financial Network, said in a note.
“Significant declines are a common and recurring feature of the stock market,” he wrote. “In that context, this one is no different. And since it’s no different, like any downturn, we can reasonably expect the markets to bounce back at some point.”
Many market veterans are bracing for further volatility. The Fed and its chairman, Jerome Powell, signaled after the September meeting that policymakers intend to continue raising interest rates aggressively into next year and not cut them until inflation has fallen. Powell has warned that getting inflation under control will be painful, requiring a period of below-trend economic growth and rising unemployment.
Many economists argue that the Fed cannot whip up inflation without plunging the economy into a recession. Powell has signaled that a hard downturn cannot be ruled out.
“Until we get clarity on where the Fed is likely to end” its rate hike cycle, “I expect to see more volatility,” Arone said.
In the meantime, there may be more shoes to drop. The third-quarter reporting season, which starts next month, could provide another source of downward pressure on stock prices, analysts said.
“We are of the view that 2023 revenue estimates must continue to decline,” Ryan Grabinski, investment strategist at Strategas, wrote in a note. “We have our recession odds for 2023 at about 50% right now, and in a recession, revenues fall by an average of about 30%. Even with some extreme scenarios – like the 2008 financial crisis when revenues fell 90% – the median decline is still 24%.”
The consensus earnings estimate for 2023 is down just 3.3% from June peaks, he said, “and we think these estimates will be revised lower, especially if the odds of a recession in 2023 increase from here,” Grabinski wrote.
What to do?
Arone said sticking with high-quality, dividend-paying value stocks will help investors weather the storm, as they tend to do better during periods of volatility. Investors can also look to move closer to historical benchmarks, using the benefits of diversification to protect the portfolio while waiting for opportunities to put money to work in riskier parts of the market.
But investors need to think differently about their portfolios as the Fed moves from the era of easy money to a period of higher interest rates and as quantitative easing gives way to quantitative tightening, with the Fed shrinking its balance sheet.
“Investors need to turn to thinking about what could benefit from tighter monetary policy,” such as value stocks, small-cap stocks and shorter-maturity bonds, he said.
How will it end?
Some market watchers argue that while investors have suffered, the kind of full-throttle capitulation that typically marks market bottoms has yet to materialize, although Friday’s sell-off carried an air of panic at times.
The Fed’s aggressive rate hikes have stoked market volatility, but have not caused a rupture in credit markets or elsewhere that would give policymakers pause.
Meanwhile, the US dollar continues to soar, rising last week to multi-decade highs against major rivals in a move fueled by the Fed’s policy stance and the greenback’s status as a safe place to park.
A break in the dollar’s relentless rally “would suggest to me that the tightening cycle and some of the fear — because the dollar is a safe haven — is starting to subside,” Arone said. – We don’t see that yet.