What Causes A Bear Market?

Street sign image from Chris Potter and stockmonkeys.com.

Bear markets typically have an economic or monetary policy catalyst. David Rosenberg, Chief Economist & Strategist for Gluskin Sheff, summed up the things to look for during a transition from a bull market to a bear market as follows, via Business Insider:

“For stocks, it always comes down to the Fed and the economy. The reality is that bear markets do not just pop out of the air. They are caused by tight money, recessions, or both.”

2015: Recession And Rate Hike Odds

Since keeping an eye on the Fed and the odds of a recession can assist us from a risk-management perspective, we will examine both in this article.

Recessions: Taking A Look At History

The line on the graph below shows the probability of a U.S. recession (1994-2003). The shaded area shows the actual recession. Notice the probability of a recession, based on the St. Louis Fed's model, was quite low between 1994 and 1999, a period when U.S. stocks performed very well. The probability of a recession began to rise noticeably in 2000.

The Recession Model 2000-2002 Bear Market

We prefer to use the Fed's recession probability model as a “monitor and adjust” tool, rather than an “anticipate and hope” tool. If you were in the stock market in 2000-2003, you probably remember that most of the large and sustained losses in stocks did not begin until late September 2000. A useful technical warning came on October 6, 2000 when the S&P 500's 200-day moving average rolled over (shown in blue below). The S&P 500 closed at 1,408 on October 6, 2000. Another warning came in the form of the Fed's recession probability model via a reading of 22.68% in December 2000. On December 30, 2000 the S&P 500 closed at 1,320. Even if we had a data lag of 90 days with the Fed model, the S&P 500 was still trading at 1,160 on March 30, 2001.