So how will the market play out?

By Morningstar |  25-03-20 | 
 

Typically, bear markets have four stages. Morningstar’s vice-president of research, JOHN REKENTHALER, delves into the subject.

Stage I: Recognition

Almost everybody shrugs off a bear market’s initial slide as being an ordinary event. The markets rise, and they fall. Treating every bad week as the bear’s arrival would not only shred one’s nerves, but would cause poor performance, should the investor act upon that instinct. Nine times of out 10, realizing a quick 5% or 10% loss would result in a permanent 5% or 10% loss, as stocks quickly return to their previous level.

The bear market is on.

Stage II: Panic

This occurs when shareholders realize that the standard advice failed. Buying on the dip wasn’t easy money, as it is nine times in 10. Rather, it led to greater damage. Along with the pain (and regret) of unexpected losses comes the surprise that the conventional wisdom was wrong. Investors’ faith is tested—and some are found wanting. They sell first, then ask questions later.

We are currently in this stage. It is difficult to apply rational analysis when so much happens, so quickly.

Stage III: Stabilisation

Stocks halt their decline, thereby ending the impression that they will do nothing but fall. The panic subsides but the situation remains grim. Investors believed during the first stage that stock prices slide on a whim. Now they realize that equities stumbled for good reason, and that until that reason is eliminated, they will continue to struggle. Shareholders’ losses will not soon be recouped.

This period is marked by turbulence. Stocks rally, sometimes furiously, only to be knocked back down. Investor sentiment varies between guarded optimism that the end is at least remotely in sight, and despair that the hope was false. This is typically the bear market’s longest period, extending for several months, in some cases like The Great Depression, a few years.

Stage IV: Anticipation

This is when stocks start their recovery. As with the bear market’s beginning, almost nobody recognises its end until after the fact. The news at the time tends to be almost unrelievedly grim, accompanied by articles about how stocks’ golden days have passed. However, some investors perceive economic improvement distantly in the future. They make their bids, and stocks begin to rise.

A classic case occurred in March 2009. The recession was in its terrifying midst. Real U.S. gross domestic product declined that quarter, and the next quarter, and the quarter after that. The Morningstar Ibbotson Conference was held that month to empty seats, with the keynote speaker predicting several more months of equity losses. The rally began the next day.

Looking Forward

 

This pattern applies to bear markets that are primarily caused by recession fears.

 However, the blueprint does not work for bear markets that arise from other causes. For example, the stock market’s grinding decline from 1973 through 1974 doesn’t map well to the four stages, because it was caused by steadily increasing inflation fears. The 2000-02 technology-stock implosion also fails the test, because the major concern as the New Era concluded was that equity prices had risen too high, not—aside from some of the Internet stocks—that earnings would disappear.

The question then becomes, does the current bear market fall into the first category or the second?

The former would be greatly preferable. With that scenario, the enormous uncertainty about the spread of the coronavirus, and the economic damage that the containment efforts will wreak, disappears over the next few months. The problems will remain large and numbers, but they will at least be known quantities—and the financial markets are adept at planning for what is known.

Should the picture become clearer, the four-stage scheme figures to be relevant. Fairly soon, I should think, stocks will enter the third stage, that of stabilization. That doesn’t mean that they won’t decline further, but the struggle will at least be bounded. Within months, not years, the stock market recovery should begin.

On the other hand, should uncertainties remain high and unresolved, perhaps because the virus’s behaviour confounds the scientists, or because the financial stimulus efforts prove ineffective, then all bets are off. I do not know how to analyse such a situation. I hope that I never shall.

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