Reveals The Economic Fundamentals Of Bear Markets So You Can Assess Market Risk

Economic fundamentals are fairly useless as timing tools, but can be extremely valuable in characterizing the investment environment for risk.

They can also determine if you’re experiencing a new bull market, or simply a bear market rally.

In this post, I’ll discuss the economic fundamentals of bear markets.

This will help you analyze conditions in the current market to assess risk.

The 3 Conditions That Typify Bear Markets

Let’s begin by understanding the fundamental conditions that typify major stock market declines:

1. Overvaluation
2. Economic recession
3. Bursting of a credit bubble

If you look at the history of bear markets (see below) since the Great Depression, you’ll notice the vast majority are manageable affairs contained within the 20-30% range.

A handful approach 50%, and only the very rare beast exceeds a 50% decline by a wide margin.

Knowing which type of bear market you’re in is critical to managing your investment risk exposure.

One useful set of clues, as discussed above, are the fundamental conditions existing at the time of the bear market.

Bear Market	Months	% Decline
9/29 – 6/32	33	87%
7/34 – 3/35	20	34%
3/37 – 3/38	12	54%
11/38 – 4/42	41	46%
5/46 – 3/48	22	28%
8/56 – 10/57	14	22%
12/61 – 6/62	6	28%
2/66 – 10/66	8	22%
11/68 – 5/70	18	36%
1/73 – 10/74	21	48%
11/80 – 8/82	21	27%
8/87 – 12/87	4	34%
7/90 – 10/90	3	20%
4/00 – 10/02	31	45%

For example, when you examine the manageable market declines in the 20-30% range (9 out of 14 bear markets listed), you’ll notice the fundamental factors typically include mild overvaluation and/or normal business recession.

They’re not usually characterized by extreme conditions, nor do they occur in environments that fundamentally change the underlying economy or regulatory law.

It’s fair to say the end of these market declines results in a return to business-as-usual. You can think of them as unfortunate and relatively inconsequential hiccups on a longer path to prosperity.

The 40-50% declines are a different animal. They’re correlated with more extreme conditions of overvaluation and/or economic recession.

For example, the two most recent bear markets began from some of the highest stock market valuations in recorded history, and both declines reached the 50% range.

When these bear markets end, there’s often some significant (but not dramatic) change to the economic landscape.

The relevant question for investors should be: is the recent bear market already complete and due to enter the history books in the 40-50% category (with a little stretch)? Or…is it just taking a break on the way to something more consistent with the Great Depression bear market?

What Sets The Great Depression Apart From Other Bear Markets

To answer that question, you must understand what set the Great Depression apart from other bear markets.

 

Yes, it had the first two factors that other bear markets possess: a correction of overvaluation and an economic recession, but it also had something much more. It included a banking and credit bubble collapse.

While tons of material has been written analyzing the Great Depression and its causes, the critical factor that led to such a dramatic deflationary collapse was the bursting of a credit bubble and the consequent banking collapse.

In other words, the history of stock market declines indicates that the really serious wealth destroyers require extreme conditions to occur.

Extreme overvaluation and extreme economic decline can result in bear markets ranging in the 50% ballpark.

These conditions are significant because they’re wealth destroyers that require many years to get back to even. It takes even longer to get a reasonable compound return on your money net of inflation.

However, the distinguishing characteristic that sets apart the rare-beast declines like the Great Depression is not only all the required conditions above (extreme overvaluation and recession), but the addition of a credit and banking collapse.

Unfortunately (or fortunately, depending on your perspective), the data sample for studying rare-beast bear markets is limited – the Great Depression and Japan’s recent “lost decades” experience being notable exceptions.

Specifically, they both had credit bubbles bursting with consequent banking panics that were preceded by extreme overvaluation, accompanied by economic recession.

Another similarity is the rare-beast bear markets include some of the greatest counter-trend rallies in history.

Did you know 8 of the 10 best days for the S&P 500 occurred during the Great Depression? What you may not want to hear is the other two “Top 10” days occurred following the 1987 collapse (10/21/87) and on 10/13/08. That’s not very good company to be in.

Similarly, the great bear markets are characterized by brief and dramatic counter-trend rallies of 35-60%, correcting 25-40% of the previous decline. All of this upside volatility is what makes it so hard to separate bear market rallies from legitimate bull markets.

Another disconcerting fact is the great bear markets result in fundamental changes to the economic and regulatory landscape.

One final anecdotal piece of evidence – great bear markets tend to correlate with instability and volatility in inflation.

This could be outright deflation, like what occurred from the 29-33 period in the U.S. and Japan recently, or inflation, such as it was seen in the 1970’s in the U.S.

The key factor is instability and increasing volatility in the inflation numbers – the absolute direction of instability isn’t important.

In Summary

What lessons can you take away as an investor?

Market declines will always exist. It’s just part of investing.

When supply for securities exceed demand then price will decline. It’s just that simple.

However, there are rare combinations of circumstances that lead to historic market declines. These include:

• Overvaluation (precedes)
• Peak profit margins (precedes)
• Economic recession (coincident)
• Rising instability in inflation typified by a move from stable, low inflation to either increased inflation or deflation (coincident).
• Increasing price volatility (coincident)
• Credit bubble resulting in a banking and/or credit collapse (precedes and coincident)

When you see a confluence of these conditions then watch out.

Related: Why you need a wealth plan, not an investment plan.

You may be facing one of those rare-bear declines that go down in the history books.