How investors can take advantage of a bear market

Experts believe central bank tightening will continue to weigh on stocks in 2023, but there could be bargains on offer for long-term investors.

The stock market has been a roller-coaster ride in recent years, with first the pandemic and then aggressive central bank tightening and the Russia Ukraine conflict causing unprecedented levels of volatility.

The top US stock indices – the Dow Jones Industrial Average, S&P 500 and Nasdaq Composite ended 2022 down 9%, 19% and 33%, respectively. The latter is officially in a bear market.

As we look ahead to 2023, many investors are wondering if this will be a better year for stock markets than 2022.

Will 2023 be a better year for investors?

The main theme for equity markets last year was defined by major central banks pushing aggressive interest rate hikes in order to stamp out inflation that emerged out of the COVID lockdowns.

Most analysts believe price increases have likely peaked across developed economies, but inflation pressures are not going away anytime soon.

While goods prices have eased as supply chains have reopened, inflation has remained stubbornly high thanks to record low unemployment and a tight labour market that has kept wages elevated.

Given this situation, experts believe many central banks will continue their monetary tightening in an effort to "finish the job", raising the prospect of a recession in major economies such as the US, UK and Europe.

The consensus among analysts is for short and shallow recessions in both the US and Europe during the current year, but some experts warn things could turn out different.

Jeffrey Schulze, investment strategist at global asset manager ClearBridge believes a US recession is likely in 2023, given that the US Federal Reserve (the Fed) has indicated its willingness to tolerate economic pain in order to restore price stability.

"The Fed remains focused on lagging indicators, which risks a delayed and more modest policy response if a recession occurs. This could result in a longer and deeper downturn relative to the short and shallow recession expected," he said in a note titled Anatomy of a Recession.

"We believe earnings present the greatest risk to 2023 as the second phase of the bear market plays out," he said.

Are there long-term benefits to a market pullback?

Although earnings appear to be at risk, the outlook is not all bad for equity investors because the market may have priced in more of the downside at this point of the cycle than usual.

Schulze pointed out that in the 12 major hiking cycles since the 1950s, the S&P 500 index has experienced a positive return three-quarters of the time, delivering an average gain of 5%.

"The current hiking cycle so far is only one of two, along with 1973, where markets suffered double-digit losses, meaning the blow from here could be softer as the path for monetary policy, the economy and earnings becomes clear," he said.

ClearBridge expects markets could retest or even break through the October 2022 lows in 2023, but said long-term investors can benefit from deploying capital methodically and opportunistically into equities.

The asset manager estimates that over the last 80 years, equities have on average fallen an additional 15.6% after breaching the -20% bear market threshold. However, on average, the market has rallied +11.8% in the year after bear market territory was reached (and +18.5% over the subsequent 18-month period), meaning long-term investors can take advantage of sell-offs of such magnitude.

"With the S&P 500 bear market threshold having officially been breached over six months ago, history suggests investors may turn out to be pleasantly surprised in 2023," Schulze said.

There is also the likelihood that the US economy could remain resilient in the near term as firms continue to hire at a robust pace, wage gains remain elevated and consumer spending is holding up. Combined, these factors should provide an economic boost that forestalls an imminent recession.

But ClearBridge also warns that robust economic growth could be a double-edged sword as it could also encourage the Fed to keep policy restrictive if inflation cools more than expected or the labour market holds up better than anticipated.

The global asset manager said it favours higher quality and more defensive equities during this transition period.