Mark Hulbert: Stock-market bulls are fooling themselves over the risk of a bear market while the economy keeps growing

An example of a bear market not accompanied by a recession came after the internet bubble burst in early 2000. During the bear market that occurred from then to the October 2002 low, U.S. GDP rose by 3.0%.

I refer to it and similar major declines as “valuation bear markets” because one of their distinguishing characteristics is a big reset in the valuations that investors are willing to put on stocks. Corporate profits continue to grow, but investors aren’t willing to place as high a valuation on each dollar of those profits.

The reason the next bear market could very well be of the “valuation” variety is that the economy seems poised to continue growing as the pandemic winds down. Economic growth might even accelerate.

Yet valuations are hugely elevated. Depending on which valuation indicator you focus on, current valuations are either almost as high as they were at the top of the internet bubble, or even higher. The bulls are kidding themselves if they think they’re immune from a bear market just because the economy is likely to keep growing.

How likely is it that the next major decline will be a valuation bear market? Consider all bear markets since 1900 in the calendar maintained by Ned Davis Research—38 in all. No fewer than 13 of them—34%—did not occur in proximity to a recession in the calendar maintained by the National Bureau of Economic Research, the semi-official arbiter of when U.S. recessions begin and end.

Furthermore, the relative frequency of valuation bear markets may be increasing,. Of the 13 bear markets that have taken place since 1976, seven—that’s more than half—haven’t been accompanied by a recession.

How value stocks perform in valuation bear markets

This discussion is particularly relevant to long-suffering value investors. That’s because value stocks typically outperform growth stocks in valuation bear markets—but not declines that are accompanied by economic recessions.

Note carefully that the “declines” I am referring to are those incurred by the major market averages, such as the S&P 500 index SPX, +1.59%, the Dow Jones Industrial Average DJIA, +0.96% and the Nasdaq Composite COMP, +2.19%. Since almost all market averages are market-cap-weighted, and since the average growth stock by definition will have a larger market cap than the average value stock, it’s almost guaranteed that the major averages will show a bear market when growth stock valuations decline significantly. But that doesn’t mean that all segments of the market will lose the same amount—or even lose at all.

Take what happened in the wake of the internet bubble bursting, for example. From the stock market’s DWCF, +1.44% March 2000 high to its October 2002 low, according to data from Dartmouth’s Ken French, the 10% of all publicly traded stocks closest to the value end of the spectrum outperformed the 10% closest to the growth end by more than 22 annualized percentage points—though they still lost ground on average. But small-cap value stocks—as represented by the Russell 2000 Value Index RUJ, +0.27% —actually rose slightly during that bear market.

Just the reverse of this situation occurred during the 2007-2009 bear market, which most definitely was accompanied by a recession. During that decline, the 10% of most extreme value stocks lagged the 10% most extreme growth stocks by more than 21 annualized percentage points.

So value investors need to be careful what they wish for when they hope growth stocks’ sky-high valuations come down to earth: that this happens without an accompanying recession.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [email protected]