Beware Of The Bear?

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Although the market saw a brief correction, it now appears that the decline has resumed and we may approach the 20 percent bear market range for the S&P 500. But if we do get into an official bear market, how low can we go—and when will it end? To help answer those questions, we first need to take a closer look at interest rates.

look at rates

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There are two reasons for us to keep an eye on rates. First, interest rates determine how much the shares are worth. Lower rates mean higher valuations for stocks, which explains the market rally we saw during and after the pandemic, as rates were cut and stocks soared. As the Fed tightens policy, raises rates again, we see valuations adjusting, driving the market down.

Second, beyond a direct effect on stock valuations, higher interest rates slow economic activity and hurt earnings. We are already seeing this in many sectors, particularly housing, and the slowdown will become more pronounced as rates go up. With low earnings growth coupled with low valuations, high rates are a double whammy for the market — as we’re seeing. When rates rise sharply, the market falls sharply, indicating the year so far. It also gives us context to answer the question of how deep and long-term the decline will be.

best indicator

To do this, however, we need to determine which interest rates are the best indicators to look at. Here, the US Treasury 10-year note can be useful. Stocks are long-term assets, making them a good indicator for valuation purposes. For economic purposes, they are a good proxy for long-term loans such as mortgages or autos. While this should work in theory, it also works in practice. Over the past five years, a change in the 10-year yield has explained a 60 percent change in stock valuation.

To understand whether we’ll hit a bear market — and how bad it will be — we need to look at interest rates. Most recently, as rates fell slightly below 3 percent, the S&P 500 was approaching fair value near 3,800. Actually, we fell there and got bounced. If rates remain around 3 per cent, it is likely to be below the threshold. But rates may not stay at that level, and they are back above 3 percent to a five-year high. If rates keep rising, valuations will go down and so will the market.

Given interest rate projections, the bond market overall expects the Fed’s rate to continue rising through the second half of the year and then possibly stop. The 10-year yield will be affected by this, although it is not entirely determined by it. It also includes a possible rate cut after the economy slows down. This could happen sooner than the market thought, with clear signs of bearishness. In any event, current expectations are that rates will continue to rise for some time. Note, however, that those increases are currently priced in longer term rates, and those expectations are very bullish.

near the end?

Those tepid expectations can be met. With signs that inflation is rolling in and speculation rising that the Fed may halt rate hikes before the end of the year, the balance of risks is likely to shift more toward less tightening than more tightening. As we have seen so far, this will keep long-term rates around 3 per cent.

If so, the valuation is already close to the low. Even if they retrace again, they may not reach the threshold of a bear market. Looking at interest rates, unless we see a fresh increase in rates, the pullback is closer to the end than the beginning. As expectations moderate, stable or declining rates will move from market headwind to tailwind.

We may have a few more months to go, in other words, especially given the weak summer seasonal market factors, but we are likely to be nearing the end of the pullback. As valuations stabilize, an increase in earnings could trigger a rebound in the market and will also be an offsetting factor.

Don’t watch the market. , ,

All of the above is probably a long-winded way of telling the old market truth: Don’t fight the Fed. And it is—but it is also an explanation of why it is true. In this case, that truism is encouraging.

Don’t watch the market, look at the interest rates. When they start falling again, the pullback will be over. And based on what we know so far? That could happen this fall.

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