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A Bear Market Might Be Headed This Way

Stocks have slid 17% so far this year, but that's nothing compared to the average bear market drop of 36%.
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Stocks have tumbled this year, with the S&P 500 dropping 17%. And a strong case can be made that they’ll fall further.

And why is that, you may ask?

First, even after the slide, valuations remain lofty. 

The S&P 500’s forward price-earnings ratio stood at 16.4 as of May 20, according to FactSet. 

That’s well above the 20-year average of about 15.7.

Stocks have generated returns far in excess of their historical averages in recent years, so a simple reversion to mean — that's fancy jargon for a return to average — would likely entail subpar returns for years.

The S&P 500 has returned an annualized 13.88% over the past 10 years, according to Morningstar. 

That compares to 10.67% for the period from 1957 through Dec. 31, 2021, according to Moneychimp. 

The index was bumped up to 500 stocks in 1957.

Inflation and Interest Rates

The rampant inflation coursing through the economy is another negative for stocks. 

Consumer prices soared 8.3% in the 12 months through April. Walmart  (WMT) - Get Walmart Inc. Report, Target  (TGT) - Get Target Corporation Report and other companies said their first-quarter earnings were hurt by inflation, as consumers struggle to afford products whose prices have increased.

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Rising bond yields and the Federal Reserve’s interest-rate hikes also are bad for stocks. 

The 10-year Treasury yield has surged 135 basis points this year to 2.86%. 

The Fed has lifted rates 75 basis points starting in March, and a lot more is expected.

Higher rates make it more expensive for companies to borrow, increasing their costs and dampening their ability to invest. 

Higher rates make it more expensive for consumers to borrow too, crimping their buying power.

Possible Recession

There’s also a high chance for recession over the next two years, and a recession is obviously always bad for stocks. 

There has never been a time in the last 65 years when inflation stood above 4%, unemployment stood below 5% and the economy didn’t enter recession within the next two years. 

Unemployment registered 3.6% in April.

Except for brief periods, what we’ve seen so far this year doesn’t even amount to a bear market for stocks, which is defined as a drop of at least 20%. 

The S&P 500 has averaged 36% drops in bear markets going back to 1929, according Ned Davis Research, as cited by the Wall Street Journal.

“We still need to shake out the froth from the markets,” Cole Smead, president and portfolio manager of Smead Capital Management, told the Journal.

The author of this story owns shares of Walmart.