Though Monday’s equity sector session shocked investors with its bearish magnitude – the S&P 500 lost 2.14% while the Nasdaq slipped nearly 2.6% -- the reality is that 2022 started off on the wrong foot. With terrifying events like Russia’s invasion of Ukraine and multi-decade highs in the rate of inflation, fears of a bear market and a subsequent economic recession have weighed heavily this year.
Therefore, it’s not surprising that several market analysts and experts have suggested a higher-level interpretation of the kindergarten expression, “turn that frown upside down.” As The Motley Fool and other publications have mentioned, bear markets are not necessarily dynamics that investors should fear. Rather, they can be a blessing.
As TMF contributor Stefon Walters stated, “Instead of looking at the negatives of bear markets, investors should view them as a chance to grab some great undervalued stocks or double down on their current holdings while prices may have been overcorrected during the current bear market.”
In principle, all rational investors fully understand this concept. Further, Walters brings up one of the favorite truisms of Warren Buffett, CEO of Berkshire Hathaway (BRK.B). “Be fearful when others are greedy, and greedy when others are fearful.”
It’s all great stuff. However, bear markets usually don’t occur in a vacuum. Here are three reasons why you need to invest based on relevant fundamentals rather than saccharine aphorisms.
Bear Markets Equate to Job Losses
First and foremost, bear markets equate to job losses. You don’t need to extend yourself back to some obscure point in the past. Indeed, you don’t need to go back at all. You are currently witnessing the direct correlation between bear markets and lost employment opportunities.
While the benchmark S&P 500 is down about 14% on a year-to-date basis and thus is presently avoiding the bear market barometer of a 20% decline, the same cannot be said about the Nasdaq. The technology-centric index has shed nearly 22% YTD.
And what’s going on fundamentally in the tech sector? Contrasting with the implications of the robust July jobs report, tech firms have been issuing pink slips.
True, bears markets tend to deflate other segments beyond equity valuations, such as the housing market. However, real estate acquisitions have always required a relatively significant amount of money, even more so today. But then, how will people take advantage of these lower prices if they’ve been laid off?
The point is, a bear market isn’t just a price discount where all other factors stay the same. No, there is a reason why equity valuations tumble – and usually not a good one. Therefore, a downturn isn’t an automatic cause for celebration unless you happen to work in a recession-insulated industry.
Rise of Risk-Off Sentiment
Another problematic component of a bear market is the rise of risk-off sentiment. Here again, one doesn’t need to go back in time (much) to realize the validity of this statement. During the onset of the COVID-19 crisis, the Federal Reserve responded with a loosening of monetary policy. Flooded with cheap money, investors of all stripes bid up thousands of stocks across myriad industries.
Even previously irrelevant strip mall video-game retailers facing an existential crisis received a dramatic boost in valuation. However, faced with the consequences of monetary profligacy, that sentiment does not exist nearly to the same magnitude today.
Speculation is simply not as fashionable, with meme stocks struggling mightily. As well, cryptocurrencies have suffered recently, likely from the buy the rumor, sell the news concept.
Moving forward, it’s going to be difficult to navigate the waters if we indeed suffer a significant economic downturn. While betting on future innovations represents a much-evangelized concept, the public companies providing said innovations must first run a sustainable business.
It was very much easier for Wall Street to gloss over the fact that many if not most tech startups weren’t profitable. In a deflationary environment, however, financial vulnerabilities present major problems.
Reliance on Debt
Finally, the last factor to consider about investing during a bear market is the overall reliance on debt. As mentioned above regarding risk-off sentiment, investors are less likely to part with their money in exchange for equity. Therefore, startups must look toward financing options rather than investor-driven capitalization initiatives.
Yet again, you don’t have to go back to appreciate the validity of this dynamic. According to a Reuters report, “Initial public offerings (IPOs) around the world raised a record $594 billion in 2021.” This year? Not so much.
One barometer to consider is the performance of the Renaissance IPO ETF (IPO), which is down a staggering 43% YTD. Another datapoint comes from FactSet, which reported that “In the first quarter, the average IPO raised just $104.7 million; in the second quarter, the average size fell to just $85 million, the smallest quarterly average since at least 2008.”
In turn, innovative but financially challenged companies must look beyond the capital markets to raise necessary funds. As well, such a circumstance limits investors’ own options, making retail acquisitions more challenging.
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