CAN THE RECENT HURRICANES BRING ON THE NEXT BEAR MARKET?

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TIGER 21

Published On

October 11, 2017

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CAN THE RECENT HURRICANES BRING ON THE NEXT BEAR MARKET?

With the bull market now into its ninth year, a question that comes up a lot these days is how long it can continue. What will finally trigger the next bear market?

There are many catalysts that can set off a bear market, but one possibility is as prominent as the story that has dominated the news for the past few weeks ‚Äì the damage done to East Texas, Florida and Puerto Rico by Hurricanes Harvey, Irma and Maria.

Now, to be clear, there is no equating financial consequences with the threat to human life and subsequent hardships that were caused by the recent hurricanes. However, when one considers the human toll taken by lost jobs and savings, the economic impacts are not trivial either, and are worth discussing. A look at the conditions that have led up to some significant bear markets in the past make it fair to consider whether the devastation caused by these hurricanes ‚Äì and in particular their potential inflationary impact ‚Äì might prove to be the catalyst that touches off the next bear market.

Market turns are not only tough to predict, but even as they occur they can be difficult to accurately spot until they are well underway. Harvey, Irma and Maria may or may not prove to be the catalyst of the next bear market, or that catalyst may turn out to be a dozen other things. However, a look at history shows that the one-two punch of the recent devastating hurricanes certainly has some of the characteristics of a bear market catalyst.

What causes the market to take a fall?

To understand how events like these hurricanes could eventually precipitate a decline in the stock market, it is instructive to look at some prominent down markets of the past 50 years:

January 1, 1973 ‚Äì September 30, 1974. Total decline in the S&P 500: 46.2%.Details about the Watergate break-in began to undermine public confidence in recently-re-elected president Richard Nixon. Leading up to the bear market, the dismantling of the Bretton Woods currency arrangement caused a sharp decline in the dollar. Oil prices began to spike in August of 1973, and then would more than double in January of 1974 due to the Arab oil embargo. Between the weak dollar and soaring oil prices, inflation rose sharply, from a 3.4% year-over-year rate at the end of 1972 to 8.7% at the end of 1973 and 12.3% by the end of 1974. All of the above took its toll on the economy, which lapsed into recession in November of 1973.
October 1, 1987 ‚Äì November 30, 1987. Total decline in the S&P 500: 30.2% This was a notably short, sharp bear market, though after this two-month decline it would take more than a year and a half for the market to recover to its previous high. Leading up to the bear market, a 32.7% decline in the trade-weighted value of the U.S. dollar contributed to a revival of inflation, which rose from 1.1% year-over-year at the end of 1986 to 4.4% by September of 1987. Another inflationary factor was a surge in oil prices, which after having collapsed in previous years roughly doubled between March of 1986 and July of 1987. The inflationary environment spurred on a steep rise in bond yields in the first three quarters of 1987. No recession accompanied this market decline, though the financial system was shaken up by the S&L scandal.
June 1, 1990 ‚Äì October 31, 1990. Total decline in the S&P 500: 15.8%.The beginning of a recession coincided with the start of this bear market, but the real precipitating event was Iraq’s invasion of Kuwait. This caused oil prices to more than double over the course of August and September of 1990. Previously, the dollar had already fallen by 7.6% in the year leading up to this bear market, and would fall another 7.4 percent by the time it bottomed out in November. The falling dollar and rising oil prices exacerbated an already troublesome inflation environment, with the year-over-year rate topping 6% in late 1990.
September 1, 2000 ‚Äì September 30, 2002. Total decline in the S&P 500: 46.3%.This market decline started somewhat organically, as a 13% correction in the last four months of 2000 seemed a fairly natural response to the overheated valuations driven by the dot-com boom. Over the next couple years though, things would get much worse. Inflation had started to revive leading up to the bear market, peaking at a year-over-year rate of 3.7% in mid-2000. That doesn’t seem too bad, but after inflation had remained below 2% in 1997 and 1998, it’s re-emergence put some pressure on interest rates. A recession began in early 2001, and the market decline steepened as a large swathe of the tech sector went belly-up. Meanwhile Enron, at the time one of the country’s largest companies, proved to be a financial shell game. Finally, the ultimate shock came with the terrorist attacks of September 11, 2001. It would be another year before the market began to recover, and nearly five years before it would regain its pre-bear market level.
November 1, 2007 ‚Äì February 28, 2009. Total decline in the S&P 500: 52.6%.A collapse in the housing market triggered a chain reaction of financial collapses, primarily due to overly-aggressive lending practices and reckless leverage. A steep recession began shortly after the start of this bear market, but even before then rising oil prices and a falling dollar caused inflation pressures. The price of a barrel of oil rose by more than 400% between the end of 2001 and mid-2008, and the trade-weighted value of the dollar fell by 35% during that same period. Year-over-year inflation peaked at 5.6% in mid-2008.

Which brings us to the present day….

History doesn’t repeat itself in a precise fashion, so no two of these market declines are exactly alike. However, when reviewing the history of each one some common themes emerge.

Recessions are more likely to follow the start of bear markets. While people often link a bear market to weakness in the economy, note that recessions are more likely to follow the start of bear markets rather than the other way around. That plus the lag in time involved in identifying a recession makes economic growth alone a poor indicator of impending trouble in the stock market.

Bear markets are preceded by a falling dollar. Even though economic growth alone is a poor indicator of impending trouble,four out of the five bear markets summarized above were preceded by a falling dollar.Those same four bear markets were also preceded by a surge in oil prices. These same two factors, a weak dollar and rising oil prices, also tended to stoke the general rate of inflation in the run-up to these bear markets.

Major events have an affect. In many of the cases above some sort of shock ‚Äì financial, political, or otherwise ‚Äì acted as kind of a flashpoint to exacerbate concerns over economic conditions in general. Which brings us back to the recent hurricanes.

The extent of the recent storms’ damage certainly qualifies as the kind of shock that undermines public confidence. Beyond this shock value, the storms could have lingering economic effects. AccuWeather estimates the cost of the recent hurricanes will total $400 million. To put that in perspective, this is more than the estimated cost of the damage done by the 2005 hurricane season, which included Hurricanes Katrina and Rita.

In terms of a potential bear market catalyst, the biggest economic impact in the aftermath of this year’s storms may be higher inflation. Houston is a major petroleum processing center, and already retail gasoline prices are up 10 percent since mid-August. On top of that, Houston is a port city that serves as an important transportation link in the supply chains of many other industries as well. As for Florida, it produces 70 percent of the nation’s citrus fruit, including 90 percent of the country’s orange juice. Taken together, the damage from these storms puts inflationary pressure on energy and food prices.

Obviously, the inflation environment has been quite benign in recent years, but inflation is at its most disruptive when it seems to come out of nowhere. Its damaging effects are two-fold: price instability hampers business decision-making, and pushing interest rates higher tends to dampen economic activity.

As for the other recurring themes surrounding bear markets, it is noteworthy that unrelated to the impact from the recent hurricanes, the dollar has declined by 7.4% so far this year. That’s not too drastic a fall, but the trajectory is troubling.

Of course, not all disruptive shocks cause bear markets, and neither do all inflationary surges or dips in the dollar. So, recent conditions, including Hurricanes Harvey, Irma and Maria, will not necessary be the culprits behind the next bear market. However, those conditions do look a great deal like some of the usual suspects.