DEEP DIVE: More on Inflation & Stocks

Strategy I: 1987-Style Bear Market?

I’ve recently been asked when was the last time we had a P/E-led bear market while earnings continued to increase.

The obvious answer is 1987. Our monthly Blue Angels framework, which starts in late 1978, shows that the S&P 500 dropped 33.5% from August 25, 1987 through December 4, 1987 (Fig. 1). From August through December, the forward P/E fell from 14.8 to 10.5. Over that same period, forward earnings rose 6.3%. The bear market lasted just 101 calendar days.

Of course, during the latest bull market, there have been 72 panic attacks, by our count, from 2009 through 2021 that included six corrections of 10%-20%. But none of them turned into bear markets because the swoons in the P/Es were quickly reversed once investors got over their fears of an imminent recession, as confirmed by the ongoing uptrend in forward earnings (Fig. 2 and Fig. 3). Arguably, the 33.9% drop in the S&P 500 in early 2020 was a bear market, but it lasted only 32 calendar days. So we included it in our list of panic attacks.

The jury is out on the latest correction. The S&P 500 fell 16.8% from January 3 through May 9. If it falls another 3.9%, the jury would have to come back with the obvious verdict: The correction has turned into a bear market. The selloff so far was triggered by two much more persistent panic attacks than the previous 72. On January 5, the Fed released the minutes of the December 14-15, 2021 FOMC meeting revealing that the committee's members were turning much more hawkish and were discussing quantitative tightening. The consequences of both developments are still ongoing and not in a good way for stocks and bonds.

Nevertheless, even if the current selloff turns into a bear market, it could be short-lived, much as was the 1987 episode. As we’ve been monitoring every week since the start of the correction, the forward revenues and forward earnings (both on a per-share basis) and the forward profit margins of the S&P 500/400/600 have remained on solid upward trends rising in record high-territory (Fig. 4, Fig. 5, and Fig. 6).

Of course, the big difference between now and 1987 is that inflation is a much more serious problem currently. In response to the 1987 stock crash, then-Fed Chair Alan Greenspan first introduced the Fed Put. This is the first year since then that the markets have been forced to discount that the Fed can’t provide the put because it must fight inflation. Hence, market participants have concluded that it’s never a good idea to fight the Fed, especially when the Fed is fighting inflation.