How to Invest for the Coming Bear Market
We may not be in an official bear market yet—but it sure feels like one. The Dow Jones industrial average plunged by nearly 540 points during the day on January 20, before finishing the trading session off by 249 points, or 1.6%. Standard & Poor’s 500-stock index logged a decline of 1.2%. Nearly 1,300 stocks that trade on the New York Stock Exchange hit new 52-week lows.
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The S&P 500, down 13% from its May high, is deep in correction territory—defined as a decline of at least 10%. To be considered a bear market, share prices need to fall at least 20% from a previous high. The typical S&P stock is already there; on average, stocks in the index have sunk more than 25% from their respective 12-month highs. The Russell 2000, a barometer of small-company-stock performance, crossed into bear market territory earlier in January, and is now 23% below its June peak.
Carnage in the oil patch is historic. As oil prices have collapsed, earnings in the energy sector have fallen 65% since their peak—twice what companies in the S&P 500 suffer during a typical recession, say analysts at Bank of America Merrill Lynch. Likewise, prices of energy stocks have fallen more than the market falls in a typical recession: 44% versus 40%.
The Bear Case. There’s good reason for the bear case. The collapse in commodity prices reflects worries about a lack of demand stemming from a steep slowdown in China, the world’s second-largest economy. Its economy grew at the slowest pace in 25 years in 2015, triggering worries of a global recession that will ultimately threaten U.S. growth. The strong dollar is taking a bite out of profits for U.S. multinational companies. It doesn’t help that investors are also worried about the course of Federal Reserve interest rate hikes and jittery about geopolitical strife at several of the world’s trouble spots.
But a U.S. recession “made in China” would be unprecedented, says economist and market strategist Ed Yardeni, of Yardeni Research. And although plunging oil prices hurt the energy industry, they are an overall plus, says David Kelly, chief global strategist at JP Morgan Funds. “The biggest impact of cheap oil is that it represents a tax cut for global consumers—hardly a threat to the global economy,” he says. Kiplinger’s expects the U.S. economy to be good but not great in 2016, with gross domestic product expanding by 2.5%.
Even if the economy avoids slipping into recession, investors won’t necessarily escape a bear market. The good news is that bear markets that aren’t associated with recessions tend to be short and shallow. The S&P 500 declined by an average of roughly 30% during recession-free bear markets in 1961, 1966 and 1987, according to BofA Merrill Lynch, compared with about 40% for bear markets that coincided with recessions. However, the more-severe a bear market, the more likely consumers are to pull back, increasing the odds of recession.