This Will Determine Where The Stock Market Goes Next
Last December the market suffered an unprecedented loss. It was, by far, the worst December for the S&P 500. While the index has recovered somewhat since, the question is: where does it go next? History strongly suggests that the answer lies in the direction of the economy. If the U.S. slips into recession, the probability of even deeper losses is significant. Otherwise, the market is probably heading for higher levels.
December was a very bad month for the S&P 500. The index fell more than 9%, far more than the previous 6% record. The entire fourth quarter of 2018 was also dismal: it was the third-worst ever, only behind 2008, during the throes of the Great Recession, and 1987, when the S&P had its largest one-day percentage loss.
Why the fourth quarter was so bad is unclear, although there are many possible reasons. A string of contradictory statements by the Federal Reserve chair, complicated trade talks with the Chinese, growing alarm at the enormous pile-up of public and private debt and the government shutdown rank high in the list. Notice that all these are U.S. self-inflicted problems.
Other worrisome issues include surprisingly bad economic numbers in Germany and China and the slow-motion Brexit disaster. Combine all this with an exhausted bull market and the recipe for bouts of panicky selling is complete.
Issues that cause deep worries to investors are always present, but they do not always cause precipitous losses like the ones experienced at the end of last year. Was the market volatility a fluke, or should investors be worried that more pain is ahead?
We looked at 120 years of Dow Jones Industrial Average history to catalog what happens to the stock market after a 20% decline from a previous peak – the conventional definition of a “bear market” and almost (but not quite) the magnitude of last quarter’s dip.
We found very few times when the market fell by about 20% and did not continue to fall afterward. Most of the time it resumed its decline, almost always in connection with an economic recession. However, when there was no recession in place, it tended to turn around and recover its value without further losses. This suggests that the outlook for stocks depends greatly on whether a recession is in the cards.
In previous posts, I have noted that chances for a recession are by no means negligible (see here and here). Since I wrote those posts, the government shutdown worsened the economic outlook. According to Kevin Hassett, the chairman of the White House Council of Economic Advisors, the shutdown will shave 0.13% off GDP each week the government is closed.
Fed chair Jerome Powell said on January 10 that he does not see evidence of an economic slowdown anywhere in the incoming data. But this may be wishful thinking, since he is lacking key reports such as housing starts, retail sales and business inventories which have not been released in January due to the shutdown debacle. Both investors and the Fed are operating without data points that are essential to find out whether we are close to a turning point.
One important issue to keep in mind is that forecasting the economy is just as challenging as forecasting the stock market. But an interesting twist is that the stock market seems to have a better ability to anticipate economic downturns than analysts do. Investors should pay heed to the December volatility.
While a recession is very often accompanied by unstable markets, the opposite is not necessarily true: not all unstable markets foretell a recession. Hence the dictum “the stock market anticipated nine of the last five recessions.” It may not take too long until we find out whether the December volatility was a warning call or a false alarm. In the meantime, investors may be well advised to keep a low exposure to risk. Even if markets continue to recover, the opportunity cost incurred by staying out could be well worth it, if it helps investors avoid further pain that pushes them to sell when it’s entirely too late.