The Russell 2000 index (small cap stocks) is already in a bear market, are large cap stocks next?

Posted by Gary Abely, CPA, CFP®, AIF®

For many investors, the start of 2016 has been anything but happy.  We are often asked two questions by our clients, “What causes a bear market and how long do they last?” and “Is the current market correction the beginning of the next bear market”.  First, let’s define the terms correction and bear market.  A correction is a decline in a market index of at least 10%.  The S&P 500® index has had 25 declines of between 10% and 20% since 1945, about one every three years, on average.  A bear market is a decline in a market index of at least 20% from a prior peak.

We have some excellent literature we can share regarding the history of bear markets for anyone interested.  To be brief here, since 1945, we have had 8 declines in the S&P 500® between 20% to 40% and 3 declines over 40% (two of which have occurred in the past 15 years).  The average length of decline in months for the eight declines (where the S&P 500® index declined 20% to 40%) was 11 months and average time to recover was 14 months.

Now, for what people really want to know.  What causes bear markets and are we entering one now?  To answer this question, many look to the S&P 500® index when determining if “the market” is in a bear market as this index includes the vast majority of the total U.S. stock market value, mainly large company stocks.  We now know that small cap stocks are, in fact, in a bear market, having dropped more than 20% from a recent peak.  Some view the Russell 2000 (small cap index) as a leading indicator for large company stocks; however, its record is spotty at predicting a bear market for large cap stocks (S&P 500® index).

Probably the best predictor of whether “the market” enters a bear market is whether or not the U.S. is entering a recession or continuing its current slow growth trajectory.  Markets typically move up or down based upon the future expectations for both economic activity and corporate profits.  Analysts pour over a multitude of data for clues about future economic activity such as: payroll data, GDP estimates (Gross Domestic Product), earnings announcements, and other leading economic indicators.

Currently, four headwinds exist which may impact U.S. economic activity and corporate profits and bears watching (pun intended).  First, a continued strong U.S. dollar makes our exports expensive to other non-U.S. consumers, thereby potentially hurting revenue for large U.S. multi-national companies in 2016.  Second, corporate profits in the first 9 months of 2015 were below 2014 levels.  The good news here is most of this decrease in profits was due to currency translations back into a strong U.S. dollar.  It is difficult to predict whether this headwind (strong U.S. dollar relative to other currencies) will continue for 2016.  Third, a slowdown in global economic activity (think emerging economies such as China) can cause less demand for commodities and consumer goods and have spill-over effects on U.S. producers (think U.S. energy market).  It used to be said, when the U.S. sneezes, the rest of the world catches a cold.  China, the second largest economy in the world, may now have a similar influence.  Finally, our Federal Reserve is navigating a new interest rate policy which adds uncertainty.  Raise rates too quickly and risk recession.  Raise rates not enough and have fewer tools in the belt to stave off the next recession.

In summary, predicting when the next bear market will occur is difficult.  It is rare for the S&P 500® index to decline more than 20% unless the U.S. economy is in or entering a recession.   The best option during uncertainty and market volatility for most investors is to continue with their long-term investment strategy.  Few investors ever successfully time a market top or bottom.

We know for all those who are still working and saving each month this is an opportunity to purchase more shares at lower prices.  Market corrections and bear markets actually help improve overall long-term returns when purchasing more shares at lower prices.  For those retired and living on their assets, on the other hand, bear markets can be especially painful.  Retirees do not have the luxury of time and therefore must be vigilant to maintain an appropriate asset allocation for their risk tolerance and income needs.  For such retirees, the “bucket” approach to investing is useful.  For example, assets needed for income over next five years should be in a safer bucket than assets needed for income ten years out.

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