Why We Might Already Be in a Bear Market

The S&P 500 Index (SPX) closed on Aug. 9, 2019 down by 3.0% from its all-time high set in intraday trading on July 26. While that’s far from the 20% retreat that constitutes the widely-accepted definition of a bear market, Morgan Stanley nonetheless says that “we are still mired in cyclical bear market.”

They offer three reasons for this assessment, based on comparisons to Jan. 2018. First, the S&P 500 is “roughly flat” since then, given that the Aug. 9, 2019 close was slightly less than 1% above the intraday high on Jan. 26, 2018. Second, 80% of global equity markets have fallen by close to 10%. Third, most of the other U.S. stock market indices, as well as most U.S. stocks, also are down by about 10%. Morgan Stanley makes these observations in this week’s edition of their Weekly Warm-Up report.

The report notes that, during the past 18 months, most stock market indices worldwide have fallen significantly from their highs, and have experienced much greater volatility than existed during the prior two years of strong bull market gains. “Almost 80 percent of all major indices we track have not made new highs and are more than 10 percent below those highs,” Morgan Stanley says. “At this point, we would view our call in January 2018 for a multi-year consolidation and cyclical bear market as well established and documented,” they conclude.

Looking at U.S. stocks, the report observes that both the small cap S&P 600 and the mid cap S&P 400 have not reached new highs in 2019, and that both are down by more than 10% from their previous highs set in Sept. 2018. Additionally, only 5 of the 11 S&P 500 sectors have set new highs in 2019, and 3 of those are defensives: utilities, consumer staples, and REITs. The other two are information technology and consumer discretionary, the latter’s performance skewed by the inclusion of Amazon.com Inc. (AMZN), “more a technological disrupter than a good read on the consumer.”

In 2018, tightening by the Fed created a “rolling bear market” which moved through every major asset class one by one, starting with the “weakest links,” and eventually sending all down for the year, “a rare occurrence in history.” This round of tightening also caused global economic growth to slow, “with the weakest economies getting hit first and hardest.”

While some observers see the recent shift in Federal Reserve policy towards interest rate cuts as a positive for U.S. stocks, Morgan Stanley disagrees. They view this policy reversal as evidence of deteriorating economic fundamentals both in the U.S. and abroad, which are bound to produce further declines in corporate profits and profit margins. With about 90% of S&P 500 companies having reported 2Q 2019 results as of Aug. 9, the report finds that their blended earnings have declined by 75 basis points year-over-year, with rising labor costs being a large factor.

“Perhaps the most convincing evidence for those who question if we are still in the midst of a cyclical bear market is the fact that long-term Treasury bonds have defeated the best equity market in the world over the past 18 months, especially since September,” Morgan Stanley asserts.

Against a deteriorating economic outlook, Morgan Stanley believes that growth stocks are more vulnerable than defensives. As a result, they favor defensives such as utilities and consumer staples, and are underweight in growth sectors such as information technology and consumer discretionary.