The global economy looks set for runaway inflation a la the 1970s, which would be good for value stocks. However, the markets also look set for a bear market or a correction, so which will it b, and what does it mean for your stock portfolio? It all depends on who you ask.
Meanwhile, the old "fear of missing out" specter continues to hover over the market, keeping some investors in names they might want to reconsider before things get too bad.
Beware FOMO
FOMO is a problem that has the potential to hit all investors, growth and value alike. It's clear that FOMO is still driving stock selection among individual investors. Data from Hargreaves Lansdown shows that retail favorites like GameStop (GME, Financial) and AMC Entertainment (AMC, Financial) were among the most heavily traded stocks throughout much of 2021.
It's now been a year since retail investors squeezed hedge funds on their most heavily shorted names. However, GameStop was still among the 10 most heavily traded stocks in January, along with perennial favorites like Microsoft (MSFT, Financial) and Tesla (TSLA, Financial).
Indeed, FOMO has been driving global stocks higher and higher, especially as retail investors poured their hard-earned cash into the markets as the pandemic raged. S&P Global Market Intelligence found that retail trading activity from Charles Schwab (SCHW, Financial) indicated a spike in activity in March 2020 and in January and February 2021. Although activity cooled in the next three quarters, the number of daily average trades was still 84% higher in December than it was in February 2020, the last month before the pandemic hit.
Fear and greed
One of the biggest problems for traders, especially for amateurs without extensive experience, is the tendency to let your emotions guide you, which is the core of the FOMO trend. Investors have been willing to pay much more than what stocks are actually worth because their emotions are telling them that they can't miss out.
However, with a bear market or correction appearing on tap, retail investors are about to be introduced to the opposite of FOMO, which is really nothing more than greed all dressed up for the masses. The opposite of greed is just plain fear, and as Warren Buffett (Trades, Portfolio) famously said, "Be fearful when others are greedy and greedy when others are fearful."
So if a bear market or correction is just around the corner, it might be time to switch from fearful to greedy, although if you've already fallen victim to FOMO, you might want to learn the hard way what it means to HODL (hold on for dear life) when the markets fall.
Bear market or correction?
The experts disagree about whether a correction or a bear market is coming. There's no denying that inflation is through the roof, so the next question centers on what the Federal Reserve will do next. Estimates of the number of interest rate hikes to expect this year range from three to seven.
Professional investors might do different things based on how many rate hikes occur and whether the Fed starts hiking in March, as some expect. As a result, we could see a bear market, a correction or a continuation of the rally that's been occurring since the fallout from the beginning of the pandemic cleared.
A correction is defined as a decline of 10% to 20% from the recent highs. On the other hand, a bear market is a decline of more than 20% from the recent highs that lasts for at least two months. In other words, we don't know if we're in a bear market until after it's been going on for weeks.
Bear markets are marked by widespread pessimism among investors and, often, a declining economy. Corrections tend to be more temporary, either snapping under a fresh rally or plunging further into a bear market. Corrections can also be a reaction to a stock price that has gotten inflated due to FOMO or other factors.
Declines in both corrections and bear markets hinge on the prices at the market's close, which means it is possible for a stock or the market, in general, to fall 10% for part of a trading day without it being considered a correction.
Argument in favor of a correction
January was a challenging month for the stock market. The S&P 500 hovered close to correction territory, resulting in the worst month since March 2020. However, the index started to rise in the first two days of February to claw back about half of January's decline.
Meanwhile, the tech-heavy Nasdaq Composite, which is particularly sensitive to interest rate hikes, fully entered correction territory in mid-January, plunging more than 10% below its record high in November. Additionally, the small-cap Russell 2000 fell into a bear market in January.
Retail investors could understandably believe the early February rally in the S&P means a continuation of the bull market. However, that's not necessarily the case, especially as the economy hangs in the balance while the Fed figures out what to do. Thus, it still would be a good idea to try to figure out whether the odds are in favor of a correction or a bear market.
David Grosvenor of Oxford Economics wrote in a note on Monday that he doesn't think this is the beginning of a new bear market, so he remains modestly overweight on global equities, but with a relative underweight on U.S. equities. He added that when the economy isn't in a recession, like now, historical corrections for the S&P 500 have shown average declines of around 15.4% with "very few resulting in bear markets."
But what about a bear market?
On the other hand, reading blog posts from Ray Dalio (Trades, Portfolio)'s Bridgewater Associates suggests that the firm may be seeing a bear market right around the corner. In a recent post, Bob Prince and Aaron Goone noted that it's important for investors to understand the drivers of a bear market and how to manage through one as the Fed begins tightening policy.
They explained how the liquidity cycle as determined by the Fed drives growth and inflation. Money can move from cash to assets and spending, resulting in a bull market and soaring inflation as investors pour capital into the markets and increase their spending. The massive amounts of stimulus that were poured out due to the pandemic lined Americans' pockets with cash. However, we've now moved from stimulus to a period in which massive growth is pushing inflation through the roof.
When the Fed determines that inflation is a problem, it starts to tighten by raising interest rates and through other policy changes. This reverses the flow of money so that it moves from assets to cash, which slows growth until inflation eases. The result is a sort of domino effect that rolls through the stock market, moving from rising inflation to an increase in discount rates caused by Fed tightening.
When the Fed's tightening is aggressive enough, risk premiums rise, further pulling down stock prices. Next is a credit contraction and downturn in growth. These factors combine to shift the stock market into a bear market.
One thing that will impact whether we see a bear market or a correction is just how aggressive the Fed gets with its tightening. As already stated, the range of expectations is wide. Some investors are pricing only three rate hikes into their expectations for stock prices, while others are pricing seven.
Bridgewater is looking for a bear market, saying the macro influences on global equities suggest "that the macro environment that we are headed into is far less supportive than what has existed over the past couple of years."
One thing to watch to see whether it's a bear market or contraction
Because the Fed has been so fast and loose with monetary policy for so long, it seems inevitable that a recession will occur when it starts to tighten, which raises the likelihood of a bear market in stocks. Data from the last 41 bear markets and 30 corrections over the last century show that corrections are marked by increased risk premiums and a decline in price-earnings ratios.
However, corporate earnings decline in bear markets, causing a much greater impact than the other factors because the economy is contracting. This tells us that the tipping point will likely be a shift in corporate earnings.
The S&P 500 is tracking at a roughly 20% increase in earnings for the fourth quarter, marking the fourth consecutive quarter of at least 20% earnings growth. However, there are signs that some companies are starting to slow, with big names like Starbucks (SBUX, Financial) and PayPal (PYPL, Financial) disappointing on their numbers. If these disappointments become more widespread, it could suggest a bear market is coming rather than a short-term correction.
How to make money in a bear market
Stocks will react every time the Fed makes a move, so the best way to make money in a bear market is to stay invested throughout every step of the cycle. However, the stocks you invest in might change at different stages, which means predicting a temporary correction or a longer-term bear market could change which stocks you buy.
Investors can try to prepare their portfolio for a bear market by positioning it for each of the forces that cause a bear market. Of course, diversification is important, as is keeping a long-term mindset instead of focusing on the short term. This can mean buying stocks whose price-earnings ratios have declined now in anticipation of when they will rise in the future, which is why bear markets can be like paradise for value investors.
Dollar-cost averaging is a great way to continue investing in a bear market without putting too much pressure on yourself to time to market. Rebalancing is also important as some stocks increase in value, enabling you to take some of the profits from your winners and invest in those that aren't doing so well now but will surge in the future.
Other ways to make money in a bear market include selling stocks short, buying high-yield dividend stocks, put options and buying defensive names like Walmart (WMT, Financial), Lockheed Martin (LMT, Financial), CVS Health (CVS, Financial) or General Electric (GE, Financial).
