The Bear Is Back: 3 Signals to Watch for a Market Bottoming

Markets pricing in a new scenario: Economic downturn

Over the past several weeks, and especially since the last Federal Reserve meeting, market volatility has been back. The S&P 500 has entered bear-market territory once again, down about 23% for the year. And while there had been debate around whether the economy could emerge from this tightening cycle in a "soft landing," financial markets now broadly seem to be pricing in a new scenario: A recession is on the horizon.

‍What history tells us about returns during shallow downturns

While every cycle is unique, history can offer some guideposts on returns around recessionary periods. Historically, market downturns in average or shallow recessions tend to be around -25% to -35%, and last around 10 to 15 months. The recovery period can also range from nine months to two years. Keep in mind that in deep recessions, the losses and recovery times can nearly double, but typically they are accompanied by some structural or systemic issues, which have not yet emerged in the U.S. economy. With equity markets down over 20% currently, much of the work to the downside may have been put in already, as financial markets price in the economic downside ahead.‍

Three signals to heed in a market-bottoming process

While the economy may continue to soften in coming months, history also shows us that markets tend to be forward-looking and can start to recover even as economic and earnings measures continue to decline. The question that investors may be asking now is, "What are the key signals to look for that show a market bottom is in place?"

Market bottoms (and market tops) are notoriously difficult to time. It is better for investors to have time in the market than to try to time themselves in and out of the markets. Nonetheless, there are signals to monitor that may help indicate that a bottoming process is underway :

• Inflation moving lower: Inflation has been an overhang on markets all year, as consumer price indexes have soared close to 40-year highs. The Fed and central banks around the world now view bringing down inflation as their No. 1 priority when setting monetary policy. The Fed has already indicated that it will continue to raise rates until it sees "clear and consistent" evidence that inflation is abating. This likely means that the Fed would want to see three to four readings lower in inflation before pausing its rate-hiking campaign.
• Bond yields stabilizing and ultimately coming down: Since the last big crisis -- the Great Financial Crisis in 2008-2009 -- bond yields have remained relatively contained and, in some cases, even near zero. For example, the 10-year U.S. Treasury yield averaged about 2.0% in the 10 years prior to 2022. This had supported financial markets, especially equity markets, as investors and companies could borrow at lower rates, had ample liquidity, and were being rewarded to take on risk.
• U.S. dollar softening: The U.S. dollar has been moving higher all year as well, with the DXY dollar index up nearly 17% this year and up 25% since early 2021. This move has been driven by several factors, including the relative rate moves by the Fed versus global central banks and the relative resilience of the U.S. economy. The dollar also tends to be a safe-haven currency for investors, especially when global growth is weakening.

The good news for investors is this: Since 1935, any time the S&P has fallen more than 20% in one calendar year, the returns in the following year are positive, and by an average of about 25%. So for long-term investors, this bottoming process may also be an opportunity – to diversify, rebalance, or put new capital to work in quality investments at potentially better prices – ahead of a potentially robust recovery.