A Brief History of Bear Markets

Three factors, singly or together, provoke the onset of a bear market: a policy of monetary restraint by the Federal Reserve , a sudden loss of market liquidity, or the outbreak of war.

As we are in a bear market in S&P 500 stocks in general, and Nasdaq stocks in particular, it's worthwhile comparing today's market with previous bear markets as a means of projecting what might happen over the next year.

Federal Reserve Actions

By far the most common cause of bear markets in U.S. history has been a policy of monetary restraint by the Fed.

Over the last year, the Fed has raised the Fed funds rate from 4.5% to the current 6.5% -- you might wonder why the markets didn't crack until March of this year. The answer is that while the Fed was raising rates, it was simultaneously letting the money supply expand at a pretty brisk rate (to head off Y2K liquidity concerns). These actions offset each other until the first quarter, when money-supply growth slowed.

In general, a restrictive Fed policy has a pretty punishing effect on stock markets. In an environment of 15% growth in S&P 500 earnings, the stock market is fairly valued, with the 10-year bond trading at 5% (the level of last fall). With the 10-year bond at 6.5% (the peak so far this year), the S&P 500 is overvalued by 33%, even after the pullback of the last eight weeks.

Fed-driven bear markets include the Volcker Recession of 1981-83. At one point, Fed funds hit 18%, about 4 percentage points more than the yield on medium- and long-dated government bonds at the time. From June 1981 to July 1982, the S&P 500 fell 22% and didn't make new highs for 26 months.

Loss of Market Liquidity

The classic example of a liquidity crisis is the October 1987 stock market crash. Despite a rising interest-rate environment, stock market valuations rose to the high end of historic measures. Fund managers had convinced themselves that a new financial derivative called "portfolio insurance" would enable them to exit stocks instantly if the market turned against them by selling short S&P 500 futures contracts. Unfortunately, the strategy depended on market makers being prepared to go long S&P futures in a falling market. In the first real test of the strategy, the market makers had neither the capital nor the stomach to take that side of the trade. Peak to trough, the S&P 500 fell 25% and did not make a new high for 21 months.

Outbreaks of War

When Iraq invaded Kuwait in July 1990, the S&P 500 fell 17% in six months and gained back the entire loss within three months. (It was a pretty lopsided war.) With the outbreak of World War II in Europe in 1939, the Dow Jones Industrials fell 24.5% over the following 12 months, ultimately declining by 38% in the months after Pearl Harbor (through June 1942).

The Cold War heated up between the Bay of Pigs invasion (April 1961) and the Cuban Missile Crisis (October 1962). Even though the economy had begun an expansion that lasted until the end of the decade, the specter of nuclear annihilation caused the S&P 500 to fall 25% by June 1962.

A Nightmare Bear Market

In the decade leading up to the 1929 stock market crash, the Dow gained 443%. However, away from the cities, farm prices collapsed as agricultural productivity soared, leading to widespread poverty. Brokerage firms allowed up to 90% margin, banks were allowed to invest in stocks, also on margin, and the Federal Reserve Bank, only 16 years old at the time, had neither the tools nor the experience of the modern Fed. In the summer of 1929, the Fed began raising rates to cool off the stock market.

That October, in a sudden break of confidence, the market plunged sharply, then continued lower to a 58% decline by January 1931. A brief rally that summer was eclipsed by more selling, ultimately taking the Dow Industrials down 89% from their high. The capital of individuals and banks was vaporized by margin calls; a wave of bank failures wiped out families' savings and corporations' working capital. This was the most extreme liquidity crisis seen in modern economic history. Neither the actions of the Federal Reserve nor the New Dealpolicies of the Franklin D. Roosevelt presidency could restore liquidity and confidence -- it took the deficit spending of World War II to turn the U.S. economy around. The Dow did not make a new high until November 1954, 25 years later.

Lessons for the Current Bear Market

So far, the current bear market looks a lot like the 1987 bear market (when it took 21 months to reach new highs). Then, as now, the Fed was raising rates. Then, as now, the stock market was aggressively valued. Although the S&P 500 has not fallen as hard as it did in 1987 (14% vs. 25%), the Nasdaq has actually fallen further (40% vs. 34%). Liquidity has been a problem, and many margin traders were taken out over the last eight weeks. It was with a sense of history that many brokerage firms tightened margin requirements last summer. (Margin lending is a big source of profit for brokerages, so this was not a decision taken lightly.)

The most encouraging development is that, at least this time around, the computer systems and procedures of the brokers and exchanges have been up to the task. On Oct. 19, 1987, investors could not buy stocks even if they wanted to because market makers wouldn't answer the phones, and the tape was running several hours behind trading.

The most disturbing development is that, even after the recent pullback, the S&P 500 remains valued at levels higher than in October 1987 before the crash.

In a recent TSC poll, about 70% of readers thought the Nasdaq would be above 5000 within 18 months. From current levels, that would be about a 27% annual growth rate (about twice the Nasdaq's average annual rate of growth). Between the loss of liquidity and restrictive Fed policy, I would have to say that is a very optimistic view indeed.