Here's Why the S&P 500 Plunged Into a Bear Market

The holiday season is usually about friends, family, and joy. This holiday season, it's been about panic on Wall Street, with the broad-based S&P 500 (SNPINDEX: ^GSPC) recording its worst December since the Great Depression. The widely followed index dipped into bear-market territory, albeit by a fraction of a point from its all-time intraday high.

Although stock market corrections of at least 10% are relatively common, with one occurring, on average, every 1.86 years since 1950, bear markets have been considerably more rare since the advent of personal computers, the internet, and exchange-based digitization. Since 1975, this will be only the sixth time a correction of 20% or more has occurred. Having information available at the click of a mouse for Wall Street and retail investors has substantially reduced the wild swings the market experienced in the early- and mid-20th century.

The finger of blame has been pointed

Right now, most folks don't really care about averages. They want to know why their beloved cash machine over the past decade has suddenly lost a fifth of its value in roughly three months' time. To that end, there's been no shortage of blame tossed around.

The trade war between the U.S. and China is probably the most often-cited downward pressure on the market in 2018. Tariffs on steel and aluminum crushed the auto industry and appliance makers, with the threat for an escalating tariff war still looming if a long-term deal isn't reached. Since we're talking about the two largest economies in the world by total gross domestic product (GDP), any disruption caused by this trade war could cascade down the line to other developed nations.

The flattening of the yield curve also has gained notoriety in recent months. The yield curve is a depiction of the various Treasury-bond yields based on maturity. Generally speaking, we'd like to see a nice up-sloping curve, whereby shorter maturity bonds have a lower yield than longer-maturity bonds. This entices banks to lend since they borrow money at short-term rates, lend at long-term rates, and pocket the difference as net interest margin.

But as the gap between short- and long-term rates narrows or inverts, it discourages lending. And it just so happens that each of the past seven recessions has been preceded by a yield-curve inversion -- although a yield-curve inversion doesn't guarantee a coming recession.

Chaos in the White House hasn't helped, either. The federal-government shutdown began this past weekend as lawmakers were unable to come to an agreement on a short-term federal spending bill. Add to this President Trump's vocal criticisms of Federal Reserve Chair Jerome Powell, and it's been more than enough to rile the stock market and send the S&P 500 to its lowest close since April 2017.

The real reason behind the stock market's swoon

While there's little doubt that Wall Street and investors are focused on these issues, I don't believe they're the true source of blame for the worst stock correction in nearly a decade. Rather than focusing on the symptoms of a declining market, let's focus on the cause: Things simply got as good as they were going to get.

Wall Street and investors are always taught to be forward looking. Over the nearly decade-long rally in the S&P 500, the justification for higher valuations had always been that corporations, the consumer, and the U.S. economy had room for improvement. But within the last couple of months, it became apparent that many aspects of the economy no longer had room for sustainable expansion.

Take the unemployment rate as a good example. The economic turnaround experienced during the Obama presidency and carried into the Trump presidency has pushed the unemployment rate to a nearly 49-year low of 3.7%. Over this span (587 months, since we don't have the Dec. 2018 data yet), just 13 months have seen the unemployment rate below 4%. Seven of these months have come in 2018.

There are forces at work that don't allow the unemployment rate to dip below 4% for extended periods of time. So I ask, how does the employment picture improve from here?

How about mortgage rates and the housing industry as another example? In Dec. 2015, the Fed began its monetary-tightening cycle, which has had a modest upward impact on mortgage rates. Considering that prospective homebuyers had enjoyed more than a half-decade of record-low lending rates, an increase in mortgage rates has left many spoiled and unwilling to compromise on what's still an historically low mortgage interest rate.

The result has been a flattening in housing starts since about the end of 2015. Again I ask, how does the housing picture get better from here with the Fed still choosing to tighten monetary policy?

In December 2017, President Trump signed the Tax Cuts and Jobs Act into law. This massive overhaul of the U.S. tax code slashed peak corporate income tax rates to 21% from 35% and made modest adjustments to the individual tax brackets. As a result, a majority of taxpayers would owe less in federal income tax. Trump's goal was to reignite U.S. GDP growth, thereby leading to wage and job growth.

However, many brand-name companies failed to use this extra cash to hire and expand. Instead, they returned it to investors in the form of a large share buyback and/or dividend. That's great in the very short term, but I must ask, how does that help public companies grow their businesses beyond 2018?

The real reason the S&P 500 plunged into bear-market territory isn't for fear of a recession, the trade war, or chaos in the White House. It's because things are as good as they're going to get for right now and the premiums that were previously bestowed on stocks with the expectation that things would continue to get better simply don't make sense any more.

Mind you, this doesn't mean we're heading into a recession, but it does suggest that a revaluation of the market is warranted. And that's exactly what we're getting right now.

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