It may be hard to remember, but the stock market started the year by making new, all-time highs. The S&P 500 (NYSE: SPY) peaked in the first week of the year at 4,818. Currently, the S&P 500 is 25% off these highs.
This type of drawdown would be consistent with a garden-variety bear market. However, there's an increasing amount of evidence that we are on the brink of something worse that could lead to a pullback of around 40%.
Here are 3 reasons why investors should be prepared for such an outcome:
Stubbornly High Inflation
The August CPI report was a game-changer in that it showed stickier components of inflation accelerating, while the more volatile (food, energy, and vehicle) components experienced deflation. Overall, it was enough to push monthly core CPI to 0.6%, well above the Federal Reserve's threshold to pause or slow its rate of hikes.
For the Fed to pause or slow, we need to see monthly core CPI decline sequentially for 3 months or go negative. The hopes of this were greater when stickier components were less elevated, while volatile components were leading us higher.
Earnings Contraction
We are seeing a serious slowing in many parts of the economy, most prominently the industrial sector and housing market. Weakness in these areas should spill over and affect other parts of the economy like employment and consumer spending even if it's with a lag.
In essence, the economy has evaded a recession for the first 6 months of the Fed's tightening. Now that higher rates are likely for the next 6 months, the odds of the economy continuing to grow and earnings expanding look unlikely.
Multiple Compression
And, this is the bear case in a nutshell. We have earnings that are likely to drop over the coming quarters, at the same time, short-term rates are likely to be higher and at the least, elevated.
This means the market is going to face the dual threat of lower multiples and lower earnings which is a combination that can lead to cascading lows in stock prices.