How Quickly Could a Bear Market Unfold?

Any day now, the S&P 500 is poised to break back above its all-time high, and will officially become the longest bull market in history in a few short weeks. The financial media is giving us a litany of reasons why the bull market is near its end: stretched valuations, trade wars, rising interest rates and inflation, and about a hundred parallels in market & economic data between today and the 2007 peak. Comparisons abound also to the dot-com bubble given today’s tech stock valuations, following years of sector strength in unison with growth stock leadership. Without doubt, these are all valid themes worth a slice of our macro analysis, but we note countless attempts to call the end of the bull market in recent years have proven invalid.

Then there are the FAANGs. A single Google search will return endless commentary that highlights the group’s market leadership, its vast weight in the S&P 500, and its contribution of a substantial portion of the index’s 2017 and YTD 2018 returns. Perhaps this point is worth looking deeper into.

If FAANGs can propel a bull market, can they drag it into a bear? Their size – not to mention their prominence, or dominance, in our everyday lives – wields an outsized influence on the stock market. And they can be quite volatile, as Facebook and Netflix have recently demonstrated. Facebook declined 18% in a mere seven days following the Cambridge Analytica headlines, rose 43% over the next four months, then plummeted 19% in just one day (hitting bear market territory just two days later) after earnings that showed slowing user engagement. Netflix hit the bear market mark square on the head, declining 19.99% in just 13 days after earnings that showed weaker-than-expected subscriber growth.

Pair their vast market composition with this volatility trait and sensitivity to myriad factors – from missed expectations and regulatory news, to mere whispers and conjecture – and you have a potentially treacherous combination that could make for a rapid onset of the next bear market.

Ok, now we sound just like a sensationalist financial media.

As we discussed in July, bear markets tend to evolve more slowly as systemic issues related to an economy or market are gradually exposed. The 2008 market crash – fresh on our minds for being the most recent and for its damaging losses – took a year of steady declines to officially become a bear. The dot-com bubble, to which many compare the current bull market given tech leadership, took over six months to hit bear market territory after bursting.. There are always exceptions – 1929 and 1987, for example. But those were different times, before the establishment of mechanisms that exist today to prevent a repeat of such instantaneous carnage (but of course, past results are no guarantee of future results, in either case).

Individual stock volatility is not new, and comparing a stock’s personal market cycle to that of the broader, diversified market may not exactly be apples to apples.  The unease today stems from the volatility inherent in the market’s largest companies. Wall Street posits similar concerns. We believe it is worth investors’ consideration.

A bear market is a bear market. The path to it may be the biggest unknown, with every correction prompting fear and uncertainty. Patient, long-term investors are accustomed to quick corrections, which often occur during a bull market and recover without harm. Yet, with the market so heavily driven today by a handful of companies, we must prepare for the possibility that a quick correction might be more.

Investors need a systematic, disciplined plan to stay on track through market volatility and the onset of a bear market; one that involves more than merely leaning on asset class diversification. Veterans of the 2008 market crash may remember all too well how correlations can go to 1.0 across even “safe” asset classes during periods of extreme market distress. This is potentially when the dark side of passive indexing may rear its ugly head. An allocation to active managers who employ a systematic plan for downside protection may be a smart consideration for your portfolio.