Since 1926, the S&P 500 index has fallen by more than 20 percent fifteen times. On average, the index fell 34 percent in seventeen months during such a period. As many as eleven of the fifteen times the market paused somewhere between 15 and 20 percent price decline, just as it is doing now.
Then some of the earlier losses were made up for. On that basis alone, there is a good chance that the fall will continue.
This cycle moves faster
The average pause during a fall of more than 20 percent lasted four months. However, during this cycle everything is moving faster. A short, deep recession in 2020 was followed by an unprecedented rapid and strong recovery, after which we reached the middle of the cycle in the summer of 2021. Less than a year later, we are already at the end of the cycle. It seems that in this cycle, months are more like weeks.
In those cases where the decline was limited to 20 percent or so, the rescue usually came from the central bank, like in 1990, 1998, 2011 and 2018. After the 1987 crash, central bankers were keen to guard financial stability. Turmoil in the stock market henceforth had potentially negative effects on the economy.
Fed-put has disappeared
It would seem that the tail was wagging the dog, but the transmission mechanism of the debts that had increased sharply since the 1980s meant that financial instability had to be prevented from now on. This phenomenon was first known as the Greenspan-put and then became the Fed-put. For the first time in more than 40 years, the central bank can no longer support the market, not with the current high inflation rate. This is also an important argument for a further fall in prices.
The decline is now even being precipitated by the central bank, at first sight aggressively raising interest rates. This brings an end to the era of quantitative easing, a period of abnormally low interest rates and unconventional policies by central banks. The era of negative interest rates is over, for good.
Unfortunately, many assets have been overvalued because of these extremely low interest rates and now a period of normalisation will follow. This has started but is far from over. History teaches us that to curb the current high level of inflation, a recession is required. With the current interest rate hikes, the Fed does not seem to want to go that far, but inflation figures will eventually force the Fed out.
Focus on disappointing corporate profits
A recession almost always means a profit recession. For the time being, there is a clear slowdown in growth, which will probably become visible in the coming figures season. The weakening of growth is causing sales to fall and, with a certain time lag, costs are also rising.
Higher interest rates, higher wages and higher energy costs. And yet the profit margins are at a historically high level. The first companies are now starting to warn that the figures are disappointing. The coming weeks are also typically the period for warning; if they wait until the actual reporting, such a company will be punished even further. Expect a bad-news show.
Due to the high level of debt, the stock market has become increasingly influential in the economy. That is also the reason why we have seen a 50 percent drop in the stock market twice this century, once after the dotcom bubble and once after the Great Financial Crisis.
The big question is still where the next financial problem will arise. It could be Europe, now that interest rates in Italy have risen from 0.6% to 3.4% in a short space of time. Or it could be a large financial institution that has proved more sensitive to the development of crypto-currencies. Furthermore, more than a fifth of the US stock market consists of zombie companies. For these companies, too, the end is approaching with the abandonment of unconventional monetary policy.
Stock markets overreact, even downwards
Markets hardly ever move in a straight line. Investors also have to adapt psychologically to the new environment. The ‹Buy-the-dip› mentality has to be turned into a ‹Sell-the-Rally› conviction. Up to April, a lot of money was still going into the stock market, also because the big rotation out of bonds had finally started.
The current pause may well make the Fed more determined. In the run-up to the second half of the year, the fundamentals for the US equity market are simply not good. Growth is slowing and with it corporate profits. Liquidity is turning; instead of buying up to 120 billion dollars a month, 95 billion dollars is being sold every month. Visually, the valuation may seem fine, but the problem is that profits are coming under pressure and stock exchanges always tend to exaggerate, both upwards and downwards.
Han Dieperink is chief investment strategist at Auréus Asset Management. Earlier in his career, he was chief investment officer at Rabobank and Schretlen & Co. His column on InvestmentOfficer.lu appears on Thursdays.
This column was originally published on InvestmentOfficer.nl.