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In our previous piece on how the markets typically react to Federal Reserve interest rate cuts, we suggested that while the reaction is generally positive most of the time, there are glaring exceptions to the rule.  We then went on to show that two conditions, if present in the market environment, have historically upset the usual bullish narrative when the Fed cuts rates.

This line of reasoning is based on the idea that when the Fed cuts interest rates, market rates generally follow the direction set by the Fed. However, as we pointed out previously, the last time the Fed cut interest rates, market interest rates defied convention and actually rose.  Since that time, we have seen this same phenomenon in Europe.  Multiple central banks have cut rates in Europe, but their bond markets are rebelling and taking rates in the opposite direction.  In Japan, the situation is even worse; their 30-year bond has just hit the highest interest rates in history!

New highs in gold and plummeting bond markets are not a healthy background for equities.  It suggests that markets are adopting a different perspective on the prospects for bondholders and the value of the currency. Coming at a time when markets are historically overvalued and overconcentrated, investors must be aware of the possibility of disruption because the stock market is priced to perfection.

However, returning to our thread of previous conversation, the two key conditions that created adverse outcomes for equities were the market valuation metrics at the time of the peak in the cycle and the real interest rate. Our study concluded that if the market is grossly overvalued and real interest rates are low, the market’s reaction to interest rates can be poor or even negative. To revisit the study, click here.

So we have two problems.  If the Fed does cut rates, the market is significantly overvalued, and real interest rates are low. The other point is that even if they cut rates, recent experience shows that market rates often do not follow the Fed’s commands and instead rise. That is what has been occurring in Europe. These two points take on more urgency as we approach the September 17th Fed reserve meeting.  It appears that the markets now expect a cut, and most are leaning towards it, believing it will prove bullish for the market. We are concerned that the market is overvalued, overconcentrated, and overleveraged, and thus vulnerable to surprise outcomes.

One of our former professional contacts has been gently chiding us for expressing caution, given the excellent sentiment and technical action of the market. He thinks bear markets are not to be feared as much as we think because most of the time, the market is in a bull phase. Not being fully in the market thus leaves one out of the action, which is overwhelmingly bullish almost all of the time.

This chart of Charlie Bilello makes this point very clear.

Indeed, it is true. Markets do spend most of their time going up (at least in US history), and bear markets on the surface are much shorter affairs.  In fact, according to this chart of the S&P dating back to 1949, the longest bear market is 2.5 years, and many last less than a year. So, what is there to be scared of?

When we first looked at this chart, we were a bit flummoxed because it did not comport with the 50 years we have been in the market.  It took a while for the elderly brain to figure out what was wrong with what this chart is saying.

What it is computing is the duration of the bear cycle.  When does the bear end?  Well, when the market quits going down and reverses to the upside.  However, that does not measure how long it takes to return to where you were before the bear interrupted our bullish experience.  In other words, while the market may go back into a bullish phase, it does not mean you have gotten your money back.

There are several challenges that we must deal with.  First is what could be called the peculiar math of bear markets. You would think that if a market fell by 30%, you would break even if the market came back by 30%, right?  No, the math does not work that way, as the table below will show.

Here’s the “bear market math” chart. It shows how much the market has to rise after a drop to break even:

• 10% drop → +11.1% recovery

• 20% drop → +25.0% recovery

• 30% drop → +42.9% recovery

• 40% drop → +66.7% recovery

• 50% drop → +100.0% recovery

• 60% drop → +150.0% recovery

• 70% drop → +233.3% recovery

• 80% drop → +400.0% recovery

• 90% drop → +900.0% recovery

This makes clear why deep drawdowns are devastating — the recovery percentages accelerate in a nonlinear manner.

For example, if you look at the time chart, the Dot-com bubble peaked in 2000, during which the S&P dropped 50%, a decline that lasted just 2.5 years. But that is just the time the market spent going down to find a bottom. It does not count either the time or the percentage recovery necessary to get even. That 60% drop took 150% to recover, and it took longer than you think.

Since recovery takes time, we created a chart showing the nominal time and then adjusted for constant dollars.  You see, as the market recovers, it often faces the headwind of inflation. Money is losing value while the market struggles to get back to your entry point. So to break even in the true sense, you must get back to the same level in constant dollars. The blue bar is the critical metric.

Let’s take another look at the 1999-2000 dot-com bubble peak. It took approximately 4.5 years to break even in nominal terms, but nearly 12 years to break even in inflation-adjusted terms. Ooops. That is a much worse beating than waiting 2.5 years. As the chart shows, in almost all cases, it took more time to recover in inflation-adjusted terms, with 2007-2009 being a recent exception.

However, in either case, the breakeven time is significantly longer than just the time spent in the bear phase.

The S&P has not been around as long as the Dow Jones Industrial Average, so we researched the problem on Dow terms to go back and capture more history.

You can see how dangerous a bear market can be by looking at the 1929 peak and the 1966 peak. It took, in both cases, almost 30 years to break even in real terms.

Now, we know what you are thinking. Surely this fellow is not suggesting a replay of the Great Depression and a 30-year breakeven.  Perhaps not, but the stagflation of the mid-1970s was just as severe, and we recall that very well. Remarkably, it took about the same time to break even as the Great Depression!

What has us concerned, though, is that, as we pointed out last time, by using a compendium of the standard valuation metrics, the current market is as expensive as it was in 1929 or 1966.  That would suggest the next bear market, whenever it begins, will not be a one-to two-year affair. 

And without being repetitive, we noted last time that the stock market today is overwhelmingly owned by the elderly, those older than 70.

It is precisely these folks who can’t wait to break even in 10 to 30 years. As we get older, we run out of time. That, and extreme valuation and market concentration, is why we are concerned. Oh, and throw in low real interest rates.

Indeed, valuation cannot be used as a timing mechanism.  It is more a statement of market condition than a statement about the market’s direction.

However, what if market technicals and sentiment turn negative, and momentum starts to shift on the downside? Given the market’s valuation and market concentration, as well as the history we have just provided, this should be a concern to every investor, especially older ones.

If that comes to pass, do you have a plan of action? Have you discussed this with your financial advisor? If you are on your own, what steps would you take differently if the market were to turn downward? What would you use as an indicator to tell you the direction of the market has changed phase from bull to bear?

We can’t provide you with financial planning advice. However, we can give you an overview of the market’s history.