Bear Markets: How to Identify a Bottom

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IN THIS PUBLICATION:

• Structural and Cyclical bear markets have different characteristics.
• We’ve not seen the bottom of the bear market yet.
• Keep an eye out for valuations, PMI, rates, and sentiment to assess when the bottom might be in place.

Structural vs Cyclical Bear Markets

No Fed, US Mid-terms, or FTX/SBF talk today - we promise.

Instead, we wanted to highlight a framework to help us get a sense of what round of the current bear market we are in.

First things first, let’s resurface Bobby Vedral’s framework for the current bear market (first published here):

“That we are in a bear market is obvious. The question is what kind. In my view there are three types: technical sell-offs (like 1987), systemic-crisis (like 2008) and healthy asset-deflations (like 2001-02). I think we are in the latter, which is only natural after 40 years of bond-bull-market and a decade of free-money. The problem with Asset-Deflation Bear Markets (ADBM) is that they are long.

Now, if we are in an ADBM, then there are three stages: first, wild up-and-down swings – to get investors tired. Then, consistent down-markets, to get investors to capitulate. Finally, a whipsaw, to discourage even the last optimist … before markets find a bottom and recover.

I think we are in Phase 1, which means I expect vicious short-squeezes while the overall trend is lower.”

Goldman Sachs has instead put forward the idea that this is a Cyclical bear market (“typically triggered by rising interest rates, impending recessions and falls in profits”, and is a “function of the economic cycle”) rather than a Structural one (“triggered by structural imbalances and financial bubbles”, where “very often there is a ‘price’ shock such as deflation and a banking crisis that follows”), which is what Bobby has been arguing in favour of.

This distinction matters quite a bit as Structural bear markets have almost 2x the downside of Cyclical ones and last for significantly longer.

Goldman does not believe this is a Structural bear market because:

• “In most structural bear markets private-sector leverage becomes very extreme, whereas currently, private-sector balance sheets are generally healthy.”
• Many markets outside of the US were not in an equity bubble.
• The “scale and breadth of the asset bubbles [like portions of the crypto market and non-profitable tech] were narrower than in other bear markets.”

Whilst Goldman’s view implies that, ultimately, there’s less downside to asset prices vs Bobby’s view, they both agree to the fact that it’s still too early to call the bottom.

• First off, valuations haven’t bottomed.
• Independently of inflation peaking or not, the belief that it will remain higher for longer is enough to put upward pressure on interest rates (which will continue to put downward pressure on asset prices).
• The release valve for inflation (and consequently for a pause in interest rate hikes) is lower demand, which is where the labour market comes in. Roger has written about this in September, but the TL;DR version is that we need to see higher unemployment to help balance supply and demand, and whilst we’ve seen some layoffs (maybe Elon is the Central Banker we all needed? Jokes, jokes!), we still need higher unemployment to slow down wage growth (higher wages = higher demand).
• Additionally, demand is not the only problem. As Goldman argues: “Most inflation periods in the past have been resolved, at least in part, by rising interest rates triggering sufficient demand weakness to alleviate the price pressures. Similarly, most economic downturns have been a function of weaker demand that has been eased by falling interest rates.” This is basically why central banks are increasing interest rates. But…
• “The current cycle is different because of the supply-side issues that have contributed to it. The combination of the pandemic and the war in Ukraine has compounded the problems that reflect a sustained period of under-investment in physical capacity. We have gone from an era of plentiful and cheap supplies of labour and energy to one in which these factors of production are scarce and expensive.
• This suggests that monetary policy alone will be a more blunt instrument than it has been in past cycles and that some inflationary pressures will likely remain stronger for longer than we have seen in past cycles since the 1970s. Consequently, markets are likely to price a combination of higher terminal rates and greater recessionary risk before a genuine bull market inflection is likely to be reached.”

To Bobby’s credit, the analogy with the asset deflation witnessed in 2001-02 has been looking pretty accurate so far.

In fact, S&P 500 performance in 2022 implies that we’re still in Phase 1 (“wild up-and-down swings – to get investors tired”), with October witnessing (for the fifth time) a sharp bear market rally. This is one of the main traits of this market – a continued downward trend repeatedly interrupted by painful bear market rallies.