Is a Bear Market Next?

Updated on 1/23/08.ADVERTISEMENT

Major stock indexes like the Dow Jones industrial average and the S&P 500 are down more than 15 percent from their record-high closes over four months ago, on October 9, and the market is shaky despite Federal Reserve rate cuts and Washington's attempts to craft an economic stimulus package. Is a bear market in the cards? Here are a few things to keep in mind:

Not everyone agrees on what constitutes a bear market. The typical definition of a bear market is a major stock index drop of 20 percent or more during a one-year period. To get technical, the index must end a session at least 20 percent off its closing peak. By that measure, the markets skirted bear-market territory Tuesday when the Nasdaq dropped more than 20 percent from its recent closing high of 2,859 set on October 31, before rebounding a bit. "This has been a horrible three months regardless of what definition we want to put on it," says Philip Orlando, chief equity market strategist at Federated Investors. "The market is clearly pricing in a recession, and we may not technically be in a bear market, but it certainly feels like a bear market."

Bear markets rarely drop in a straight line. Writes John Hussman, money manager and economist, in his weekly market comment: "Instead, they typically include several declines of 10-20 percent, punctuated by very hard rallies." He notes that the 2000-02 bear market included three separate advances of about 20 percent each, measured from intra-day low to intra-day high.

The next few weeks are going to be a test. How can you tell a bounce from a slide? Says Quincy Krosby, chief investment strategist at the Hartford: "If it's a bear market, it's not going to be a market that goes back up and stays up. It will be a market that lags, that loses energy, and falls into a malaise or a funk. We need to see if again we'll test the bottom and start building and buying on weakness, or if we've been enveloped by the bear."

The Fed still has ammo left. Although the Federal Reserve cut its federal funds rate by three quarters of a percentage point today, there's a good chance it may cut again next week. According to futures listed on the Chicago Board of Trade, investors are pricing in a 70 percent chance of at least a quarter-point cut, to 3.25 percent. "The market is betting on sharply lower rates from here," says John Canally, investment strategist for LPL Financial. "Today's move caught the Fed up to about even, and it needs another 50 basis points for the market to be satisfied that the Fed is ahead of the curve rather than behind." Both Goldman Sachs and Deutsche Bank expect a half-point rate cut next week. According to research published by Deutsche Bank Tuesday, every intermeeting rate cut since 1998 has been matched by a similar-size rate cut at the ensuing meeting.

If this is a bear market, it is probably just beginning. Since 1926, the average bear market has lasted 1.3 years, according to Jim Stack, president of InvesTech Research. Only two of the past 15 bear markets have ended in less than six months, according to Stack. Since 1940, more than half of the bear markets have ended in less than a year. Since the S&P peaked 3� months ago, in October, that would mean chances are that if this is indeed a bear market, it will not soon be over.

But remember, this is a presidential election year. Since 1940, 81 percent of presidential election years have seen gains in the S&P 500 index, according to Stack. Also since 1940, only one presidential election year (2000) has seen over a 3 percent loss in the S&P 500. Even in three out of four other presidential election years that saw the start of a bear market (1948, 1956, 1968, and 1980), the S&P 500 index finished the year with a gain.