The S&P 500 finds itself at a crossroads as we peer into the fall of 2022. Having sold off 23.5% of its value from early January through mid-June, it had regained precisely half of the ground lost on the eve of the late-August Jackson Hole Economic Symposium. Investors are left wondering: Is this the end of the market’s weakness? Or just the beginning?
The Classification of Bears
There are, broadly, two types of bear markets. Classification is tricky as there’s no formal authority designating bear markets. Conventionally, any decline of 20% is considered a candidate. But if that is the measure, the range is wide indeed. It is unmistakably clear in examining history that certain down markets stand out in terms of severity and duration. These outliers we classify as secular bear markets. They are not quickly remedied and are a kind of purgatory for the oft-financial and sometimes-economic sins of excess. They’re the grizzlies of the bear-market family. We’ve written before on their relevance for long-term investment returns.
The last century has seen many bear markets. Most, however, are at best a black bear (1961–62). Maybe even a panda (1948–49). The declines are mainly contained between 20% and 30%. The S&P 500 has recently seen drawdowns of similar magnitude. In Q4 of 2018, the index dropped nearly 20%. The losses were reversed by April 2019. Even the large decline of 34% in 2020 was erased within five months. The severity and duration of these events place them squarely in the territory of the so-called minor bears.
The most dangerous variety of bear market, however, is noticeably different. They are the stuff of legend. These are the events that occasion Ph.D. dissertations and endless commentary decades later. They are the episodes of 1929–32, 1973–74, 2000–03, and 2007–09.
Several features distinguish them from their garden-variety cousins.
First, the secular bear market is notable for its magnitude. The dispersion of these declines is centered surprisingly close to 50% in the S&P 500, with 1929–32 as the principal exception. They are not mechanical-feedback-loop flash crashes like 1987 and don’t result from exogenous shocks like 2020. They are protracted, typically lasting well more than a year (an average of 26 months). The final reckoning requires time because a secular bear market signals reorganization at a fundamental level in the underlying economy. Weak firms go bankrupt. Consumers scale back their expenditures to right-size their debt burdens. Corporate earnings contract. While the market is forward-looking, it can be months or even quarters before sufficient data are available to seal the fate of the final decline.
Second, secular bear markets are frustratingly nonlinear. Though hindsight will reveal the sustained decline, intermediate rallies can leave even experienced professionals fumblingly unsure about the future direction. Conveniently and seemingly coincidentally, the mathematical averaging of historical prices helps to smooth out their volatility and assists in identifying the prevailing trends amid the noise. Among the popular “moving” averages, the 200-day is most relevant to discerning and defining the secular bear market.
The final feature of a real grizzly is the behavior of these rallies in relation to the 200-day moving average. The countertrend rallies endemic to all bear markets are a function of multiple variables. Mechanically, short covering can drive prices higher. Psychologically, early downdrafts routinely fail to break investor confidence as weak economic data are still typically lacking. As markets retrace losses, optimism is restored, and fear of missing out brings investors back to the table. In the first major rally of a secular bear, usually 6–9 months from the peak, 50% of the decline is recouped and the index moves back to the now-descending 200-day moving average. The still-outwardly upbeat but inwardly deteriorating economic and financial data reassure pundits and investors alike that all is well — and it’s quite common to see forecasts for new highs ahead. This is, in the irony of markets, typically the last reasonable time to exit the bear market before the profound descent, but few do.
In the wake of such supposedly restored fortunes, the bad economic data arrive. Job losses are greater than expected. Housing is weakening more than the consensus suggested and the antecedent knock-on effects in the economy spark widespread worry about contraction. Concern about corporate earnings and the upbeat projections priced into equities presage a durable descent as investors begin to capitulate to the desperate portrait painted by the facts.
The largest losses across a secular bear market are concentrated in the final third of the total decline. And this is what makes the secular bear (aka grizzly) so dangerous. After the first two-thirds, it appears the bear market has met the characteristics of a standard bear classification. These first two-thirds have always totaled losses of at least 20%. The wicked kicker, though, is that the most gut-wrenching phase of the decline has not yet begun.
Wrestling with Grizzlies
The distinct challenge of bear markets is having an inkling of when you’re dealing with the garden variety or the grizzly. The taxonomy begs the question: Where are we today? The end or the beginning? Have we experienced a garden-variety bear market? Or are we on the brink of a secular one? Another way of asking the same question: Why should the current downtrend have a fate different from 2018 or 2020? On retracement, both markets sliced through their 200-day moving averages with ease.
Market dynamics since the Great Recession of 2007–09 have been fundamentally altered by intervention from the Federal Reserve. There is little doubt that deeper and more fundamental pain would have materialized in 2009 had the central bank not intervened. In fact, it was fear of a repeat of the 1930s that rationalized the do-whatever-it-takes intervention. Since the market stabilized in the spring of that year, however, the economy hasn’t been given an opportunity to stand on its own. Like a helicopter parent, the Fed has flooded the system with liquidity at the slightest wobble.
Consequently, not only were the technical bear markets of 2018 and 2020 garden variety, but they were fleetingly brief. In retrospect they appear more as moments of price distortions than changes in market trend. What they would have been without Fed intervention is unknowable. What is known, though, is the intervention that occurred. In 2018 the Fed, finally making headway on its long-telegraphed tightening program, put an immediate halt to its nascent hiking cycle. Further, by September 2019, it intervened again when the plumbing of global funding markets began to clog. It opened a “repo” facility to provide liquidity to banks suddenly short of reserves.
When the COVID lockdowns suddenly sparked a major crisis in March 2020, the central bank responded with a veritable tsunami of support, pressing against the very legal limits of its charter, to ride to the rescue of a global economy spiraling into panic mode. Paired with fiscal intervention by Congress, the cash coursing through the economic veins allowed the supply shocks of the crisis to metastasize into the re-emergent inflation currently afflicting the meager savings and paper gains of an economically traumatized public.
It is inflation that can turn this current bear market into a grizzly. A confluence of social and economic dynamics has formed an intersection likely to somewhat constrain the conventional reactions the Fed can have to the latest economic data.
The bank’s mandate is to maintain price stability and full employment. It interprets this mandate broadly. For the last decade it has argued that the wealth effect from elevated markets could be effectively pressed into the service of lowering unemployment. The structural deflationary forces of globalization allowed it and the Treasury to partner in minting money that posed few obstacles to its mandate. In recent months, that calculus has largely reversed.
Supply-side dynamics have challenged the deflationary trend. Poor demographics have, for the moment, given labor a modest lever against capital. Reshoring of manufacturing has begun following the COVID breakdowns in supply chain, which the continued zero-COVID policy in China has exacerbated, and will likely press prices even higher. Despite its array of tools, the Fed has only one lever against these forces: liquidity constraints.
The central bank can (a) raise interest rates and (b) drain bank reserves. In a highly indebted economy, both options slow economic growth, which presumably will slow inflation. The Fed no doubt hopes this happens before job losses become politically untenable. If the labor market remains quiescent, its path on inflation is clear.
Higher rates are kryptonite for financial assets. Further, many other variables currently threatening asset prices remain — from recession in China and Europe to increasingly fraught geopolitics.
A recent study argues that 60% of the recent inflation has resulted from increased consumer demand. Demand cannot be laid wholly at the feet of the Fed, however. The Treasury was a willing accomplice in stimulating the consumer. The political class is unlikely to raise taxes to do its part in containing the damage, though, leaving the Fed alone to purge these misdeeds. And note: The central bank is not truly independent. That façade of governmental institutions’ neutrality has crumbed in the face of the recent judicial machinations. There is ample political pressure for the bank to do most of the dirty work.
If 60% of inflation is from the demand side, however, arithmetic would indicate that 40% is from supply shocks. Success suppressing excess demand would still leave inflation above the Fed’s self-imposed target. Conventional wisdom holds that the supply side will right itself, but secular changes like demographic labor shortages and reshoring may thwart that expectation even in the face of recession and consumer weakness.
Three additional variables need mention.
The first is the Ukrainian war. Its geopolitical and economic dynamics are as well-known as they are unpredictable.
The second is energy investment. Like it or not, the global economy is still in almost every way derivative of fossil fuels. The anemic investment in oil extraction is coming home to roost. Further, in an electric economy, industrial metals become an even more fundamental economic input. The mining sector has also seen sustained underinvestment in the era of tech darlings and digital fantasy.
The last supply dynamic is climate. A little-advertised but significant risk to consumer prices is the mounting liabilities of a less predictable climate. The current energy crisis blames renewables and ESG (environmental, social, and governance) for the scarcity of fossil fuel. But the droughts in Europe and Asia have contributed materially to this crisis as hydro power has been constrained.
Further, the floods in Germany and China (2021) were estimated to cost $40 billion each in damages. So far in 2022, floods have cost China another $13 billion. Pakistan (early September 2022) will cost much less by virtue of its already poor infrastructure, but the scale of the damage should make developed nations shudder. Insurance companies have taken notice. Floods in Seoul saw insurer stocks drop as the damages to the luxury neighborhood of Gangnam far outstripped actuarial estimates.
Spending on climate damage counts toward GDP, but does not add productive capital to the economy. As insurers balk at the increased risk, producers will be forced to pass on increased costs to customers. This is inflation that cannot be fought with supply-chain efficiency. It is also largely impervious to interest-rate increases as it is not so much a matter of discretionary consumption as survival.
The Fed, however, struggles with nuance. Higher interest rates don’t reflect a newfound humility and preference for yield to savers over gains from speculation, or affinity for market forces. They are merely the hammer with which the central bank approaches virtually all economic remodeling. If it abandons its 2% inflation target, it risks forfeiting all credibility — the beater with which it bludgeons markets into submission. Secularly higher inflation poses political problems the bank must fight, even if it lacks sufficient weaponry.
The reason the 2022 encounter with the 200-day moving average line may differ from 2018 and 2020 is that the backdrop has changed, but the Fed’s tools haven’t. The market may eventually be the least of the central bank’s concerns. Sustained secular inflation would create political pressure for the bank to act in such a way that its support of inflated markets would no longer serve its mandate, at least until unemployment becomes an obstacle. With valuations still well above their long-term average, the gapping distance to that level would be a grizzly indeed.
 1929–32 = 35 months. 1973–74 = 21 months. 2000–03 = 28 months. 2007–09 = 21 months.
 The 50-, 100-, and 200-day moving averages are calculated using the closing prices for days when the markets are open. After the market closes on a given day, that day’s price is added to the average while the oldest is removed. Thus the “moving” average. Although technical analysts find helpful information in the juxtaposition of the three averages, the 200-day best represents the long-term trend at the expense, as is evident in the adjacent charts, of having the longest lag.