The final act of the bear market cycle

In the short-term there continues to be a long list of reasons to be concerned about the health of the economy and financial markets. The war in Ukraine rages on and appears to be escalating further, with little signs of either side in the conflict backing down. Inflation remains stubbornly high and central banks around the world continue to respond with higher interest rates. Those higher rates and the rapidity of the rises have resulted in an unexpected crisis among some less well capitalised / managed banks in the United States and Europe. We’ve even had another round of bail-outs to banks, reminiscent of the 2008 crisis.

This steady drumbeat of economic and confidence headwinds understandably resulted in a major bear market for equities last year. It was also a tough year for bond markets.

We are now well past the 12-month mark on this bear market cycle and so it makes sense to re-assess the stage of the cycle we’re in and how investors should be thinking about being positioned through the remainder of 2023.

The start to 2023 in equity markets has been characterised by relatively low volatility and positive moves up in many equity indexes. S&P 500 and Nasdaq are up so far in 2023 year-to-date. This positive start, however, may simply be yet another short-term rally in an otherwise downward trending bear market. We have been here before where short-term optimism has been mis-interpreted as a sustained new rally in stocks, only for markets to turn negative again.

In interest rate and bond markets, we are seeing a different story. There has been much greater volatility, with some of the sharpest moves in volatility for bond markets seen since 2020. This is an early indication that the calm in equity markets could change soon.

Further, when we look at equity markets, breadth has been coming down. What does this mean? Breadth is a measure of how many stocks in an index or stock market are participating in the broad direction of the market. High breadth means a lot of the stocks in the index are moving up, or down, together. This is a strong signal of the sustainability of that market direction. Low breadth means the opposite, and in the current market we see low breadth in this recent move.

That means most of the move up we have seen in stock indexes like Nasdaq, for example, is being driven by a small number of stocks, while many other stocks have been flat or declined. This historically has been an indicator of market fragility and potential weakness in the short-term.

All-in all, therefore, we are somewhat negative on the very short-term and see the balance of risk to the downside for equities in the short-term.

But, given that this bear market is now more than 12 months old, we expect that the next bout of market volatility and test of lows for markets could be the beginning of the final act of this bear market cycle.

It’s rare for bear market cycles to last much beyond 12-18 months, so even on this basic metric of cycle duration, we should be coming into the final phase of this cycle over the coming 6 months.

The later stages of bear markets in the past have often been interspersed with sharp short-term rallies, much like the recent rallies we have seen in equities. These are then followed by sharp declines and spikes in volatility, often more severe later in cycles.

We think long-term investors should be aware of this likely coming short-term volatility in markets because it will help inform decision making if and when it happens. Our advice is to look through the short-term volatility if it comes, remain focussed on the long-term, and use the opportunity of lower prices to add to risk assets trading on reasonable valuations.