Tuesday, January 31, 2023
HomeMarketStocks Need 1 Big Drop to Beat Bear Market. History of Crashes...

Stocks Need 1 Big Drop to Beat Bear Market. History of Crashes Shows Why. 

Stocks have rallied, but remain in bear-market territory.

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Stocks may be putting this year’s bear market behind them, but history indicates it may take one more downward jolt to end the debacle.

There is some positive news. The
S&P 500
has gained about 10% from its lowest close of the year, hit in early October, but it is still down in the mid-teens in percentage terms from the record high it reached in early January. Stocks enter a bear market when they fall 20% from a high, and they are considered to have moved out of one with a gain of 20% from a low.

That means that while the index has made a comeback, it is still in bear territory.

Driving the recent bounce has been hope that the Federal Reserve will soon pause the aggressive increases in interest rates it has rolled out to rein in inflation. The idea is that higher borrowing costs reduce demand for goods and services, but they also tend to weigh on stock prices and corporate profits, not to mention risking a recession.

“Recessionary bear markets historically have often ended with a capitulation,” wrote analysts at BNP Paribas. “We are calling for a capitulation event in equities next year.” 

Capitulation in the stock market is when investors sell in droves, without a specific triggering event, because the chances that business conditions and corporate profits will worsen are high. Stocks could fall even without capitulation, if the Fed raises rates higher than expected, or the economic damage still to come from the increases earlier this year turns out to be worse than analysts penciled in when forecasting corporate earnings.

But even if those concerns aren’t borne out, the market could just sell off — or capitulate.

The level of volatility now in the market indicates that the potential capitulation is still to come, according to BNP.  Over the past 100 years, its research shows, the VIX peaked at a median level of 40.5 as markets hit bottom ahead of recessions. The index is at 23 now, but its high point this year was only in the mid 30s.

That implies that the market hasn’t hit bottom, and that volatility is likely to rise when it does. The point to remember is that volatility reflects uncertainty, which means markets see a wide range of potential outcomes for earnings and stock prices. Uncertainty, in turn, means more selling.

For the several months leading up to a recession, the negative correlation between the VIX and the S&P 500 historically has become increasingly pronounced, meaning that the VIX shoots higher and the market benchmark falls. So if volatility increases—and it likely will — the stock market will drop again. 

It isn’t that the market isn’t showing any positive signals. It’s just that it is likely to throw one more fit before it resumes posting sustainable gains. 

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com

Credit: marketwatch.com

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