Historically, on average a bear market caused by a recession leads to more than a 30% decline in the stock market over a 1-1/2 year period. The bear market of 2000-02 led to a 50% drop in the S&P 500, while the bear market during 2007-09 led to a 58% drop in the S&P 500. Investors who lost 58% needed a 138% return just to get back to even.
The key part of our strategy is that we will not always be fully invested in the stock market. We would alternatively invest in money markets or Treasuries. We also will not stay fully invested in bonds at all times.
The Federal Reserve Board’s monetary policy becomes too restrictive, typically indicated by an inverted yield curve. This is when short-term interest rates are higher than long-term interest rates.
The earnings for an industry, particularly the weaker companies within this industry, are less than the anticipated forecasts over time. Eventually, this carries up to the better companies. While we attempt to buy the best, we also closely monitor the worst.
Other time tested economic, technical and psychological indicators turn bearish.
One early warning sign of a major market decline (typically a 20%+ market drop) is rising short-term interest rates. We know that a significant tightening by the Fed in an attempt to contain inflation and/or intense speculation brings about this rise in short-term rates.
We are always on alert when the Federal Reserve is tightening interest rates, especially when it leads to an inverted yield curve. An inverted yield curve is when short-term rates (Fed funds or 90-day T-bill rates) are higher than long-term rates (Ten-year Treasury bond yields). As you can see from the chart below inverted yield curves typically lead to a recession a bear market in stocks.
Chart courtesy of Ned Davis Research
The following table shows that rising short-term interest rates have the potential to create a major market peak. All major peaks have been preceded by rising short-term rates.
Major stock market tops are usually signaled well in advance by a dramatic rise in short-term interest rates over a long period of time. This increase in short-term interest rates acts as a depressant upon stock prices, corporate earnings, and the economy. Most major stock market declines occur against a rising interest rate trend.
With our sell strategy and overall conservative reduced-risk investment philosophy, over longer time periods, we often have protected the downside to our clients’ portfolios while still participating in the market advances*.