Why are stocks on the brink of a bear market? Stagflation, the Federal Reserve and what investors need to know

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It will take more than Friday’s big rally to allay fears of a bear market in stocks, as uncertainty over the Fed’s ability to rein in inflation without sinking the economy stokes fears of stagflation, a pernicious combination. slow economic growth and persistent inflation.

Stagflation is “a terrible environment” for investors, often causing stocks and bonds to lose value simultaneously and wreaking havoc on traditional portfolios divided 60% into stocks and 40% into bonds, said Nancy Davis, founder of Quadratic Capital Management.

That has already been the case in 2022. Bond markets have lost ground as Treasury yields, which move in the opposite direction to prices, soared in reaction to inflation hitting its highest level in more than forty years along with expectations of aggressive monetary tightening by the Federal Reserve. Since the S&P 500 Index’s record close on Jan. 3 of this year, stocks have been on a slide that has left the large-cap benchmark on the verge of formally entering bear market territory.

The iShares Core US Aggregate Bond ETF
AGG,
-0.43%

it is down more than 10% year-to-date through Friday. Tracks the Bloomberg US Aggregate Bond Index, which includes Treasuries, Corporate Bonds, Municipal Bonds, Mortgage-Backed Securities, and Asset-Backed Securities. The S&P 500
SPX,
+2.39%

It has fallen by 15.6% in the same section.

The situation leaves “virtually nowhere to hide,” analysts at Montreal-based PGM Global wrote in a note last week.

“Not only are long-term Treasuries and investment-grade credit moving almost one-for-one, but selloffs in long-term Treasuries also coincide more frequently with down days in the S&P 500.” they said.

Investors seeking solace were disappointed on Wednesday. The long-awaited April US consumer price index showed the annual pace of inflation slowing to 8.3% from a more than four-decade high of 8.5% in March, but economists expected a sharper slowdown, and the core reading, which excludes volatile food and energy prices, showed an unexpected monthly rebound.

That underscores fears of stagflation.

Davis is also a portfolio manager for the quadratic interest rate volatility and inflation hedge exchange-traded fund.
IVOL,
+0.69%
,
with approximately $1.65 billion in assets, which is intended to serve as a hedge against the increasing volatility of fixed income. The fund holds inflation-protected securities and has exposure to the spread between short-term and long-term interest rates, he said.

The rate market today is “very accommodating,” he said, in a telephone interview, indicating expectations that the Fed’s interest rate increases “are going to create a disinflationary environment,” when it is unlikely. that the tightening does something to solve the problems on the supply side. that are plaguing the economy in the wake of the coronavirus pandemic.

Meanwhile, analysts and traders debated whether Friday’s stock market rebound heralded the start of a bottoming process or was simply a rebound from oversold conditions. Skepticism from one fund ran high.

“After a week of strong selling, but with inflationary pressures easing only at the margin, and the Fed apparently still committed to 50 basis point hikes for each of the next two [rate-setting] meetings, the market was primed for the kind of sharp rally endemic to bear market rallies,” said Quincy Krosby, chief equity strategist at LPL Financial.

Mark Hulbert: The beginning of the end of the stock market correction could be near

“Friday’s bounce managed to cut this week’s losses by nearly half, but despite massive bullish volume, overall volume was below average and it will take more to think even minor lows are at hand,” said Mark Newton, head of technical strategy at Fundstrat.

It was quite a rebound. The Nasdaq Composite
comp,
+3.82%
,
which entered a bear market earlier this year and fell to a nearly 2-1/2-year low last week, jumped 3.8% on Friday for its biggest daily percentage gain since Nov. 4, 2020. That cut its weekly drop to a still considerable 2.8%.

The S&P 500 rebounded 2.4%, almost halving its weekly decline. That left the large-cap US benchmark down 16.1% from its record close in early January, after finishing Thursday just shy of the 20% retracement that would meet the technical definition of a bear market. . The Dow Jones Industrial Average
djia,
+1.47%

it rose 466.36, or 1.7%, leaving it down 2.1% for the week.

Read: Despite the bounce, the S&P 500 hovers dangerously close to the bear market. Here’s the number that counts

And all three major indices are on long weekly losing streaks, with the S&P 500 and Nasdaq each falling for six consecutive weeks, the longest period since 2011 and 2012, respectively, according to Dow Jones Market Data. The Dow posted its seventh consecutive losing week, its longest streak since 2001.

The S&P 500 has yet to formally enter a bear market, but analysts see no shortage of bearish behavior.

As Jeff deGraaf, founder of Renaissance Macro Research, noted on Wednesday, correlations between stocks were in the 90th to 100th decile, signifying a closed return that suggested the stock was trading largely in unison: “one of the defining characteristics of a bear market.

While the S&P 500 has moved “uncomfortably close” to a bear market, it’s important to note that large stock market pullbacks are normal and occur frequently, analysts said. Barron’s noted that the stock market has seen 10 bear market pullbacks since 1950, and many other significant corrections and pullbacks.

But the speed and extent of the recent rally is understandably affected by investors, particularly those who haven’t experienced a volatile downturn, said Randy Frederick, managing director of trading and derivatives at the Schwab Center for Financial Research, in a statement. a telephone interview.

The rally had seen “every sector of the market go up,” he said. “That’s not a normal market” and now the worm has turned as monetary and fiscal policy tightens in reaction to high inflation.

The appropriate response, he said, is to follow the same tried-and-true but “boring” advice often offered during volatile markets: stay diversified, hold many asset classes, and don’t panic or make massive portfolio changes.

“It’s not fun right now,” he said, but “that’s how real markets work.”

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