Overcoming “Walls of Worry” in the Equity Markets
Wall Street lore tells us that bull markets reach a point where they climb “walls of worry.” Certainly, we have seen that this year, as investors have worried about the aging economic cycle, rising inflation, higher interest rates, the potential for a global trade war, and other threats to the nine-year rally.
Under the right conditions, those risks could easily plunge us into a bear market. But are we worrying too much? While we should not ignore serious risks, they need to be interpreted against the economic backdrop. Knowing the history of market cycles and how economic cycles evolve allow us to be more objective about major “walls of worry.”
Bear Market Indicators
First, we need to realize that economies do not usually die of old age; they die when critical resources grow scarce. As resources tighten, sellers gain power to raise prices. Eventually, broadening price increases are reflected in elevated inflation statistics and the Federal Reserve (the Fed) is forced to raise interest rates. Finally, because of higher rates and tightening lending standards, businesses and consumers have less money to spend, and the economy ultimately slows.
Critically, it takes the better part of a year for the process to move all the way from monetary tightening to economic slowing, which poses a major problem for the Fed. Especially when inflation accelerates quickly, the Fed often raises rates multiple times before they know how much impact the earlier rate hikes have had. Generally, that causes them to overshoot by tightening to the point that the economy sinks into recession.
Although that long lag complicates the Fed’s work, it provides investors a window of time to confirm that the cycle is ending. The yield curve and money supply show some of the first signs that tightening has reached critical levels. Then, economic indicators — such as unemployment claims or manufacturing purchase orders — weaken as the effects of tightening spread through the economy.
In the early stages, there are minimal indications of weakness, but as the effects of tightening spread and the signs of weakness broaden, the odds of recession rise.
Because most major equity declines have involved recessions, deteriorating economic conditions also indicate an increased likelihood of bear markets (equity declines of 20% or more). Historically, after significant economic weakening, bear market losses occurred over the next 12 months 90% of the time. That may not seem surprising, since most people assume that large market losses accompany severe economic weakness. It is surprising, however, to learn that markets fell 20% or more after economic weakness had already become fully apparent.
Reasons for Optimism
Clearly, weak economic indicators tell us we should worry about the potential for major market declines. But do strong economic conditions tell us we can afford to worry less? Historically, they have. Whereas 20% market declines occurred 90% of the time economic conditions had deteriorated, they occurred only 5% of the time when the economy remained strong. Even in periods when equity markets showed high levels of investor defensiveness, bear markets developed only 17% of the time if economic conditions remained strong. Although robust economic conditions do not guarantee there will be no bear market, they do make major declines markedly less likely.
Strong economies may also make nervous investors less likely to act defensively. For market technicians, narrow market breadth results from defensive investor trades. Historically, significant narrowing occurred 90% of the time when the economy showed obvious weakening. But when the economy remained strong, major narrowing occurred only 7% of the time. Since investors presumably had reasons to worry more than 7% of the time, the results imply that investors do not act on anxieties as quickly when the economy remains strong.
The Road Ahead
Arguably, investors do not worry about things that have absolutely no basis in fact. Historically, however, strong economic conditions have clearly been associated with lower risks of a bear market. Whatever fears arise during strong economic times are apparently less likely to translate into major market declines.
History tells us that the current outlook for equities is better than the prevailing “walls of worry” suggest. Monetary indicators do not yet show critical tightening, and economic reports have remained strong. Even investor confidence has improved after the correction earlier this year. Historically, that pattern indicates only a 7% chance of a bear market in the next 12 months.
Obviously, conditions may change as the Fed continues to tighten or if an event like a broad trade war disrupts the economy. Yet despite the risks, until the economy weakens significantly, it seems we should monitor the threats closely but be cautious about acting on them.
About Bruce McCain, Ph.D., CFA®
Bruce McCain is the Chief Investment Strategist for Key Private Bank, where he monitors the economy and the financial markets and serves as part of the team that formulates investment strategies for clients. He supplies frequent insights to media throughout the region and around the country. His comments and interviews have been featured in such publications as The New York Times, The Wall Street Journal, Investor’s Business Daily, and Business Week, as well as on television outlets such as CNBC and Bloomberg TV. He is also a regular source for wire services such as the Associated Press and Reuters and is a Contributor on Forbes.com.