We’re in a bear market now, even if the S&P500 managed to claw above the oft-quoted 20% down definition on Friday. Importantly, the standard 20% off the highs is only the symptom of the bear market that rages. Bear markets emerge to bring reality to false expectations of the future. Low interest rates beget speculation and imagination; high interest rates bring reality front and center. And we had foolishly speculative low interest rates for over a decade, and absolutely manic money creation for the last two years–there is a lot of speculation and imagination that is coming back into sober focus. So how much lower? The obviously correct answer is “who knows”? Yet I think one call I can confidently make is that this bear market will not end until either 1) we are at much lower valuation levels* or 2) the Fed changes course. Current market speculation of whether we are in a bottom is mistaken hopes that the pain will just go away. When you understand that the current market valuations have been largely driven by easy (way understatement) money and credit conditions, coincident with what has been called the “Fed put” (the Fed’s implicit guarantee that they won’t let markets crash), the withdrawal of that monetary support framework and the Fed’s explicit statement that they are willing to put up with market pain (e.g., there is no more Fed put), then you realize markets could have a long way to go. In the midst of this week’s carnage, the Fed’s Esther George reiterated:

“I think what we’re looking for is the transmission of our policy through market’s understanding, and that tightening should be expected,” George told CNBC’s Steve Liesman during a “Squawk Box” interview. “So it’s not aimed at the equity markets in particular, but I think it is one of the avenues through which tighter financial conditions will emerge.”

Investors should be always aware of the Wall Street adages “Don’t fight the Fed” and “Money makes the mare go”; they are flip sides of the same coin. In this monetary environment the direction is down. And the Fed says they have only gotten started:

George said “we need higher interest rates,” but added that she’s comfortable with the pace the Fed is moving at now and doesn’t see the need for bigger jumps, such as a 75 basis point increase that some have suggested.“

Moving deliberately, making sure we stay on course to get some of those rate increases into the economy and then watch how that’s unfolding is going to be really the focus of my attention,” she said. “I think we’re good at 50 basis points right now, and I’d have to see something very different to say we need to go further than that.”

Unlike 2000 and 2008, I am not now shorting the market, even though I’ve thought this is almost a sure thing down. I simply don’t trust the Fed. After their mismanagement of the last two years especially, I’m not confident that if we go down a fair amount, that they won’t ease money quick (as they did in Mar 2020). Now that we’re into the bear territory, their language, per the discussion above, seems to be committed. But my best guess–and its only a guess–is they’ll continue tightening and the market will fall maybe 20% more, and then we go into a recession, and they reverse course. Probably before the inflation is wrung out. Notice our problem in prediction is not in economic analysis directly, but rather on our speculation on what government policy will be.

One more note, don’t be fooled by sharp rallies in a bear market being a new bull (as some hope for by Friday’s late day rally). The largest one day spikes in market history are almost always driven by short squeezes. Go back and study some of the ~5-10% Nasdaq rallies in the 2000 dot com crash.

Bonus blog point.

In the “why do we ever listen to Ben Bernanke” category (yes, the same former Fed Chairman who every step of the way before and during the financial crisis repeatedly told us that all is well, “subprime is contained,” “there can’t be a national housing market crash” etc, this week admitted that the current Fed blew it on this one (after following his pathbreaking QE lead):

New York (CNN Business)The first rule of running the Federal Reserve is: You do not criticize the Federal Reserve. An unspoken edict amongst former Fed chairs has been to not speak ill of their successors to preserve the apolitical nature of and trust in the institution.

But former Fed Chair Ben Bernanke broke those rules on Monday morning when he said that the central bank had erred in its approach to addressing 40-year-high inflation.”The question is: Why did they delay that? … Why did they delay their response? I think in retrospect, yes, it was a mistake,” he said during an interview on CNBC’s Squawk Box Monday. “And I think they agree it was a mistake.”

Bernanke led the Fed through the financial crisis of 2008 and oversaw incredible levels of monetary expansion. His successors Janet Yellen and then Jerome Powell, who now runs the central bank, continued the loose policy well into economic recovery.

To elaborate on this, I was giving my barber an earful on the Fed (shock!) a couple of months ago, and he said roughly “hey, I don’t mean to be rude, but how can you–a professor at a little school in Cedarville–know more about what’s going on than they do.” I told him that’s a good question, although I did defend my academic background (Master’s work and one PhD field in monetary economics from good universities, not from a cracker jacks box), but suggested the reason is not that I’m so smart (I’m not), but that institutionally you can’t trust them to speak the truth, as noted in the first line of the article quoted above. Ben Bernanke knew the market was imploding before and during the financial crisis (albeit maybe not as much as it really was initially, and then he was overly pessimestic–“we stood at the edge of the abyss”) but he couldn’t publicly say that. Imagine the chairman of the Federal Reserve saying in early 2008: “I think we really blew it with those negative real interest rates from 2002-2005. Along with the Federal governments push to create more affordable housing, we’ve created a monstrous housing bubble, and I think its collapse will cause a financial panic.” The Fed chairman cannot be expected to be an honest academic economist, even if he/she were to think that. They have to be a cheerleader for the status quo. It’s not that we’re that smart, it’s just that they can’t be honest. And its compounded by the fact that most of us want to be lied to.

And that’s the sad state of the world today.

* On the market as a whole; some individual stocks have been hammered so much that they aren’t far off a more normal valuation. But if we get a waterfall decline at some point, as I suspect we will if the Fed doesn’t change course, even those stocks will suffer in the decline. Paradoxically even safe assets, such as gold (because of their high liquidity), get sold off in panics as firm’s facing liquidations have to sell off their best assets to raise cash, and selling other assets would result in fire sale losses.