After 18 months of exceptional gains in the stock market, it might not be a bad idea to prepare for what might come next. Investing should never be about only looking at the upside, without also considering the downside. The point is, we have – despite all the predictions of doom and gloom following the pandemic – enjoyed one of the most extraordinary periods in the stock market.
But as sure as night follows day, bear markets tend to follow bull markets. We were given a taste of what to expect when global markets were subjected to a sudden and violent shift on Monday, Aug 5. It seems that a confluence of factors that included war, stubborn inflation, rising US unemployment, Warren Buffett jettisoning part of his stake in Apple, recession, concerns over excessive investment in AI, and hedge funds sleepwalking into yen carry trades unleashed a sudden onslaught of fear on stock markets around the world.
Traders took fright. The Nikkei in Japan plunged 11 per cent, the Dow Jones Industrial Index fell more than 1,000 points, and seven months of gains in the Straits Times Index since the start of 2024 were wiped out in a matter of minutes. The febrility of the market has since been assuaged. But apart from that, nothing much has changed.
Boom and bust
So, after a year and a half of exceptional stock-market gains that has seen the S&P 500 rise more than 45 per cent since late 2022, it could be sensible to prepare for some of the unpleasantness that bear markets can bring.
A bull market is when share prices rise 20 per cent from a recent low. A bear market is when share prices fall 20 per cent from a recent high. Precisely why we have bull and bear markets is a little unclear. However, many economists accept that there will inevitably be boom and bust cycles. What tends to happen is that economies tend to grow for long periods, and then they contract before they can start to grow again.
Part of the reason could be due to central banks providing too much liquidity when there is an economic downturn. They did precisely that during the great financial crisis of 2008, when panic-stricken central banks pumped unprecedented amounts of cash into the global economies. But before they had a chance to fully withdraw the cash, they were forced to pump even more money into global economies during Covid-19.
Worrying signs
Central banks have tried to dial back on their generosity through higher interest rates.
But there can be a lag before the higher cost of money is transmitted through an economy. Worryingly, inflation still appears to be higher than many central banks would like. At the same time, there are tangible signs that economic growth is finally coming off the boil.
The latest disappointing US jobs numbers could be a harbinger of tougher times ahead for the rest of the economy. That could make the Fed’s job harder, given that its dual mandate necessitates delivering price stability and creating maximum employment.
Some might argue that the Fed’s objectives are diametrically opposed. Can it really bring down inflation without causing unemployment? So fulfilling both objectives could be unachievable. Put another way, we can’t make an omelette without breaking eggs.
Consequently, an economic slowdown may almost be unavoidable.
But as economies expand and contract, they can also have an impact on company earnings. And since the performance of shares tends to be linked to company profits, it is not too surprising that stock markets can rise and fall, too.
During a bull market, most shares tend to rise. Some shares may go up, even though they may not entirely deserve to rise. It is what some have described as “a rising tide lifting all boats”. Consequently, we may find that our portfolios have grown in value without too much effort on our part. But it is still important to keep an eye on valuations to ensure that earnings have kept pace with rising share prices.
In this regard, knowing something about the company that we invest in should help us judge whether a price rise is justified. Knowledge about the company will also help us decide whether to take advantage of a price decline if that should happen. It will help us differentiate between general market pessimism and signs that there may be something fundamentally wrong with the company.
The point about bear markets is that they happen. We have had eight in the last 50 years. So, on average, they happen every six years or so. The last one was in 2020.
The next one might not occur until 2026. But we shouldn’t set our clocks by them. Instead, we should always be prepared. What’s more, we should not look upon bear markets as something that damages our wealth, but instead as punctuation marks in a rising market where we have an opportunity to buy shares when they are cheaper.
Note: An earlier version of this article appeared in The Business Times.
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Disclosure: David Kuo does not own shares in any of the companies mentioned.
