S&P 500: The Bear Market Phase 1 Completed – Here's What Comes Next

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I have been publicly bearish on S&P 500 (NYSEARCA:SPY) since March 25th, and since then SPY is down about 9-10%. The bearish thesis is fairly simple – the Fed’s aggressive monetary policy is likely to cause a recession, and consequently a bear market. Specifically, every Fed’s tightening cycle since 1945 caused a recession (with 3 soft landing exceptions, which I don’t think will apply in the current case).

However, I also analyzed all 10%-plus S&P 500 drawdowns since 1986 and concluded that there are really three major triggers that cause selloffs, and the full bear market actually comes in three phases: 1) the expectations of Fed’s monetary tightening, 2) the expectations of an imminent recession, and 3) the credit crunch.

Phase 1 sell-off

The current total SPY drawdown of 15% YTD in 2022 has been the Phase-1 sell-off in expectations of the Fed’s aggressive monetary policy tightening. Specifically, on Dec 31st, 2021, based on Federal Funds futures, the market expected the Fed to increase the Federal Funds rate to approximately 0.80% by the end of 2022. Now, the market expects the Fed to increase the Federal Funds rate to approximately 2.80%.

Thus, the market adjusted from pricing a very gradual interest rate normalization to a very aggressive monetary policy tightening. Here is the chart, showing the Dec 2023 Federal Funds futures contract, and the significant adjustment since Dec 2021.

Barchart

In addition to increasing the Federal Funds rate, the Fed also signaled the ending of the Quantitative Easing program (which actually ended in March), and the beginning of the Quantitative Tightening program, or the reduction in the balance sheet, which is expected to start in May at $95 per month.

The direct effect of the Quantitative Easing program was reflected in the negative real interest rates, as estimated from the yields on 10Y TIPS. Specifically, on Dec 31st, 2021, the yield on 10Y TIPS, or the real interest rate, was -1.04%.

The market adjusted to the expectations of the Fed’s ending the QE program, and the commencement of the QT program, which caused the yields on 10Y TIPS to increase from -1% in Dec 2021 to 0.15% by May 2022.

Here is the chart of the yield on 10Y TIPS, which shows the sharp increase in 2022.

FRED

Thus, S&P500 ETF corrected by approximately 15% in 2022 YTD, given these primary Phase 1 bear market drivers:

  • First, the increase in real interest rates, in expectations of the Fed’s QT program essentially removed the liquidity from the stock market. Thus, the high beta speculative sectors that depend on liquidity sold-off significantly. The SPY sell-off was led by a 23% drop in Communication Services (XLC), a 20% drop in Consumer Discretionary (XLY), and a 19% drop in Technology (XLK).
  • Second, the expectations of an increasingly aggressive Fed monetary tightening increased the probability of a recession, as the spread between the yields on 10Y Treasury Note and the yields on 2Y Treasury Note inverted in March.

Here is the chart of SPY that shows a significant sell-off in 2022.

Data by YCharts

The last leg down in April of 2022 of more than 10%, which was one of the worst monthly drawdowns, was specifically triggered by the extremely hawkish comments by the Fed Chair Powell at the IMF summit where the Char Powell signaled the increase in the Federal Funds rate of 50bps in May, and possibly in June. Some Wall Street analysts raised their forecasts even further to 75bps in June and July.

The Fed has six meeting scheduled by the end of 2022, and currently the market expects the total of 2.50% increase in the Federal Funds rate from the current levels of 0.35% to about 2.80-85%, which would imply on average about 40bps hike in each meeting.

More importantly, since the initial increase in hawkishness after the Powell comments at IMF on April 20th, the market has been pricing the less aggressive monetary tightening in 2023 and further, while the 2022 forecast remained stable. Thus, in my opinion, we are currently past the peak hawkishness recorded in late April 2022.

In support, the inflation expectations, as proxied by the 10Y Breakevens, also peaked in late April and remained below the 3% level. Thus, we might be past the peak inflation expectations level as well.

Thus, in my opinion, the Phase 1 of the bear market is now likely completed – the stock market and the bond market adjusted to the Fed’s expected monetary policy tightening.

Phase 2 bear market – next

Whether the bear market continues or not depends on whether the Fed’s monetary policy tightening actually causes the recession. If not, the current SPY drawdown might be near the bottom, and it will be recorded as a sub-20% correction.

The financial markets are currently not pricing an imminent recession. Specifically, the spread between the yield on a 3-month bill and the 2-year Note is positive – the probability of an imminent recession is very low.

Once the yield on a 3-month bill reaches and exceeds the yield on a 2-year Note, and the yields on a 2-year Note start falling, the market will start pricing an imminent recession – and accordingly the Fed lowering the Federal Funds rate. Note, at this point, the unemployment rate will have to start rising. We are currently nowhere near this point.

Phase 3 bear market – taking the step even further

The total drawdown will depend on how deep and severe the actual recession is. The recession of 1990 was very mild, and the total drawdown was less than 20%. However, the more severe recessions cause the spikes in credit spreads – which actually causes the ultimate Phase 3 of the bear markets and the most severe forced selling. Credit spreads are currently still very moderate, based on historical values, and the market is not pricing the credit crunch at this point.

Implications

Investors in S&P 500 ETF are experiencing a 15% drawdown at this point. Unfortunately, SPY is vulnerable to more heavy losses given the heavy exposure to Technology sector at 27% of the total index, and another 20% with Consumer Discretionary and Communication sectors together – that’s nearly 60% of the Index.

However, in my opinion, the Phase 1 of the bear market is completed. Thus, investors who fail to sell should probably hold on and wait for the opportunity to sell at a higher level, or whether to sell at all – it really depends on whether the actual recession follows, and whether the recession is deep enough to cause the credit crunch.

From the point of view of SPY short seller, the easy money on short side has been made in this Phase 1 of the bear market. The Phase 2 of the bear market has not begun yet, and the market will likely be very volatile as some short sellers will be forced to cover at much higher prices.

Thus, I am currently tactically neutral on S&P500 more likely to play the relief rally on the long side, Strategically I am still bearish expecting the Fed-induced recession – just imminently.