Inflation’s impact on the stock market
Stocks can generally act as a buffer against the long-term impacts of inflation.
Investors now have a lot on their minds — inflation, market volatility, worries about a potential recession, etc. The possibility of a bear market for stocks adds even more stress for investors.
Our latest Advisor Authority study found that only 39% of investors said their 12-month outlook was optimistic.
In this article, we’ll explore what constitutes a bear market (as well as its counterpoint, the bull market), review the history of bear markets, and discuss how you can help your clients navigate a bear market, so they make informed financial decisions.
A bear market is typically defined as a 20% decline from peak to trough. The S&P 500® Index, the benchmark index for U.S. large-company stocks, slid into a bear market officially in June after falling 23% from its last peak on January 3, 2022 (the first trading day of this year.) Stocks rallied over the summer to reclaim some of these losses, but the rally lost steam in September. As of the market close on October 7, the S&P 500 is off over 22% from the start of 2022, meeting the standard definition of a bear market.
A bull market begins at the bottom or trough of the previous bear market. In the moment, it’s impossible to know when a bear market ends, and the next bull market begins, as no one can predict what will happen in the market the next day, week, or month. We know that historically, bull markets last longer than bear markets on average and that bull market gains have far outpaced bear market losses.
Since 1932, bear markets have occurred every 56 months, or four years and eight months, according to S&P Dow Jones Indices. The average bear market lasts 9.6 months, according to Ned Davis Research. The last bear market happened at the outset of the COVID-19 pandemic but lasted only 33 days, just over one month. The previous bear market occurred in 2007-09, during the Global Financial Crisis.
Find more insights on the historical performance of bear markets.
It’s never one thing that leads to a bear market or contributes to any move in the stock market. There’s always a mix of factors at work that can sway trends in the market, either to the upside or the downside.
The most significant influence on stock performance is corporate earnings; stock prices move up or down based on investor perceptions of the current value of future company profits. Of course, earnings and profits are dependent to a large extent on economic performance (although not for all companies and not all in the same manner.)
The economic cycle of expansion and recession does affect the stock market by affecting company earnings. So, recessions can lead to bear markets. However, we’ve had bear markets without recessions and recessions without bear markets, so there is no strict cause-and-effect relationship here.
Investor psychology also has a strong influence on the emergence of bear markets. While bear markets come around every several years, it’s more common for markets to go through short periods of minor losses of 5% or 10%. Fear often builds among investors as market losses accumulate. A vicious cycle could occur where anxious investors sell their stock positions and push prices lower, which increases anxiety and leads more investors to sell their stock holdings, and so on. As panic moves the cycle faster, a bear market becomes more likely.
Cash and short-term bonds are where panicked investors typically park the proceeds from their stock sales. These are traditionally safe and conservative investments where values don’t fluctuate much. However, investors usually don’t move from stocks to cash until they’ve already sustained significant losses. Plus, given the low rates of return on cash and compounded in the current environment by high inflation levels, investors may make a bad situation worse by panic-selling in a bear market.
Because bear markets tend not to last too long, investors should resist the urge to sell off their stock holdings. A bear market may reveal to investors that they are over-exposed to more risk than they are comfortable with. In this case, a risk tolerance review with a financial professional can help align your holdings with your true risk tolerance.
Traditionally, some investments perform well in bear markets, often in businesses that are usually resistant to changes in economic conditions. For example, consumers purchase necessities such as food and personal care items no matter what’s going on in the economy. People also still need electricity, gas, and phone service in an economic downturn. Utilities and consumer staples stocks are considered defensive investments because of their resilience to changes in the economic cycle. They may experience losses, but historically not as much as in other business sectors.
Dividend stocks also allow investors to buffer drops in investment value with some return from a share of company profits. Dividend stocks tend to be less volatile than stocks for companies focused on growth and reinvesting profits into their businesses. This can help temper some fluctuations in overall portfolios.
Bonds can also help investors weather the turbulence of a bear market by bringing balance to an investment portfolio. Typically, in a recession, the Federal Reserve lowers interest rates to help stimulate the economy, which generally helps to reduce interest rates for all types of bonds. When interest rates fall, bond values rise. However, this has not been the case this year; bonds have been just as volatile as stocks as the Fed raises interest rates to counter inflation. The value of bonds in moderating stock returns comes over the long term, so they should be considered part of your overall long-term investment strategy.
To help your clients stay on track to their long-term goals in a bear market, focus on the temporary nature of bear market downturns and adjust their portfolios that align with their true risk tolerance.
This material is not a recommendation to buy or sell a financial product or to adopt an investment strategy. Investors should discuss their specific situation with their financial professional.
Except where otherwise indicated, the views and opinions expressed are those of Nationwide as of the date noted, are subject to change at any time and may not come to pass.
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