Preparing for Bad, Worse, and Worst

What markets do and don't do... Three kinds of bears... Prepare for the worst... The capital war... Three negatives hanging over the market... You know what to do...

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The stock market goes up about two-thirds of the time...

From 1896 to 2024, the Dow Jones Industrial Average ended the year with a gain in 85 out of 128 years. That's 66.4%, roughly two-thirds, of the time of the time.

Likewise, from 1927 to 2024 the S&P 50 Index was higher in 66 out of those 97 years. That's 68% of the time.

There's no reason to suspect that the "stocks go up two-thirds of the time" trend won't continue.

But it doesn't tell the whole story...

Even during periods when stocks go up most years, like from 1966 to 1982 when stocks rose in 10 of those 16 years (62.5% of the time), the Dow Jones Industrial Average didn't make one new high from January 1973, at the top of a steep bear market, until November 1982.

It's clearly possible for stocks to finish a nearly two-decade period with a nominal capital gain of zero (and an inflation-adjusted capital gain of less than zero).

The best investors always look down before they look up. They spend time worrying about their downside before they think about their upside. In short, you have to learn how to avoid permanent losses to be a successful investor.

Most folks probably aren't thinking about bear markets right now...

Not with the S&P 500 around 5% from making a new all-time high... and stocks up roughly 17%, as we write, from their panicky April 8 bottom. It was another dip successfully bought, as far as anybody can tell.

It's true, stocks fall less frequently than they rise from year to year. And they rarely fall two or more years in a row. But when it happens – especially when the market falls 30%, 40%, or more – it can ruin investors who aren't mentally prepared. Investors who can't ride bear markets out or take advantage of them to buy great stocks on sale will likely sell at a big loss and stay out of the market until stocks are no longer as attractive.

So today, let's look at the three different types of bear markets. I (Dan Ferris) will explain why I believe a long, steep bear market is inevitable... and how you can prepare for the bad-, worse-, and worst-case scenarios.

A Goldman Sachs report published on April 8 – the bottom of the recent decline – defined three types of bear markets...

• Event-driven
• Cyclical
• Structural

According to Goldman, event-driven bear markets are "triggered by a one-off 'shock' that either does not lead to a domestic recession or temporarily knocks a cycle off course."

Cyclical bear markets are "typically triggered by rising interest rates, impending recessions, and falls in profits." This is the most common type of bear market.

Structural bear markets are "triggered by structural imbalances and financial bubbles." These are the deepest and longest bears, with an average loss of about 34% and an average duration of about 25 months.

The March 2020 bear market that lasted one month was clearly event-driven – a response to the initial pandemic shock. The 2022 bear market was arguably cyclical, triggered by rising interest rates.

Goldman said the recent decline was event-driven...

The market reacted negatively to President Donald Trump's chaotic tariff announcements beginning on April 2. Once the initial fear passed, stocks rallied sharply.

The investment bank also suggested the decline had the potential to morph into a cyclical bear market. That doesn't seem to be playing out, with the S&P 500 up 17% or so from its April 8 low.

But the market has yet to make a new all-time high, and even if it does, we could still see another steep decline. I'm afraid that would be worse than a cyclical bear market. I see a greater risk of a deep, long, structural bear market. I'm talking about a two- or three-year steep decline, like what happened in the dot-com bust or the 2007 to 2009 great financial crisis.

Here's why...

The definition of a structural bear market hinges on two factors: "structural imbalances" and "financial bubbles."

Structural imbalance is the entire rationale for Trump's trade policy. The U.S.'s large trade deficit with other nations – most importantly China – means we're buying more goods from them than they're buying from us.

The U.S. prints the world's reserve currency, then buys things from all over the world, sending dollars everywhere. Those dollars are then invested in U.S. financial assets like stocks and bonds. It's a seemingly virtuous circle in which the U.S. gets low-cost goods while other countries get a sound currency to bolster their foreign exchange reserves, providing economic stability.

In 2024, the trade deficit rose 25% to $1.13 trillion.

Trump wants to shrink that deficit...

Whether you agree or disagree with him, he thinks other countries are "ripping us off" and he wants trade to be more balanced.

Besides the prospect of tariffs making goods more expensive for U.S. consumers, there's another, larger implication...

Simon White, a macro strategist at Bloomberg, delved into this problem in his essay titled, "The Trade War is Prelude to Global Capital War":

Trade wars are damaging for markets and the economy. But their logical consequence – a capital war – could do even more harm. The imbalances that have built up will cause potentially trillions of dollars of capital to shift around the globe, generating instability and likely prompting governments to take action to limit or direct its flow. The dollar faces a secular weakening, other currencies are at risk of overvaluation, while US assets are exposed to capital outflows.

A shrinking trade deficit will naturally lead to shrinking foreign investment in U.S. stocks and bonds. As White points out:

Simply speaking, the US owns too few foreign assets relative to what foreigners own of the US, and vice versa for trade-surplus countries, who often own US assets. The logical consequence of tariff policy is that imbalances will shrink. Trade nationalism will lead to capital nationalism.

And the imbalances are big. The gap between total assets and liabilities (the net international investment position, or the sum of previous financial account balances including valuation effects) is trillions of dollars for several countries. The US is a true outlier, having [a net international investment position] of -$26 trillion. The vast proceeds from the US's large trade deficits over many years have ended up back in US capital markets and US non-financial assets.

That means other countries have invested $26 trillion more in the U.S. than the U.S. has invested in them.

Huge structural imbalances and radical changes in government policy are already roiling global markets. Like hedge-fund mogul Ray Dalio recently said, it's not just about tariffs. The big imbalances are the real story, and they won't go away, no matter what Trump does.

A capital war could push U.S. stocks down – for a while...

The reordering of global trade promises to reallocate trillions of capital out of U.S. stocks and into places like Europe and Asia. If the ultimate goal of balanced trade is achieved, it'll mean a more balanced investment landscape, too.

Right now, the U.S. dominates global capital markets. It's 71% of the MSCI World Index, which accounts for 85% of developed countries' total market capitalization... despite that U.S. GDP is only 26% of global GDP.

Meanwhile, we are also still in a massive financial bubble, with the S&P 500 trading at a cyclically adjusted price-to-earnings ratio of about 36. Historically speaking, that's mega-bubble territory.

With a potential, radical reallocation of capital and a mega-bubble, I must conclude that a long, steep, structural bear market is more likely than ever right now.

I'm not making a prediction. I'm just saying history and the current macro environment tip the odds more in favor of a structural bear market. The odds could tip the other way, depending on how Trump handles the trade imbalances. The better Trump does, the less likely we'll face dire negative consequences. But frankly, I don't see how investors who hold risk assets in the U.S. could possibly escape some degree of a negative outcome, even if it's not as disastrous as I'm afraid it will be.

If Trump is successful, money will flow into the U.S. economy from other countries. But it won't pump up U.S. asset prices.

Instead, it'll bolster demand for U.S. goods as countries like China will wind up buying more goods from the U.S. One example of those goods is natural gas. The U.S. is loaded to the gills with the stuff, and exporting it to foreign markets will be a boon for domestic producers.

On another positive note, rebalancing trade could drastically slow the rate at which the U.S. government issues new debt...

That would help keep interest rates from spiking too much higher.

But all the positives remain out in the future somewhere.

Right now, the bond market seems to be casting a disapproving eye on the government's finances. Wednesday's auction of 20-year U.S. Treasury bonds saw weaker demand than expected, causing the 30-year bond yield to rise above 5% for the first time since October 2023. (Remember, yields rise as bond prices fall.)

Trump's much-touted "big, beautiful bill" is the likely culprit. It passed in the House yesterday, and the more astute folks in Congress are worried that it'll raise U.S. government debt levels by as much as $3.1 trillion in the next 10 years.

As we wrote on Monday, credit-ratings agency Moody's also recently lowered the government's credit rating from its highest rating, Aaa, to Aa1. It said...

This one-notch downgrade on our 21-notch rating scale reflects the increase over more than a decade in government debt and interest payment ratios to levels that are significantly higher than similarly rated sovereigns.

Successive US administrations and Congress have failed to agree on measures to reverse the trend of large annual fiscal deficits and growing interest costs. We do not believe that material multi-year reductions in mandatory spending and deficits will result from current fiscal proposals under consideration. Over the next decade, we expect larger deficits as entitlement spending rises while government revenue remains broadly flat. In turn, persistent, large fiscal deficits will drive the government's debt and interest burden higher. The US' fiscal performance is likely to deteriorate relative to its own past and compared to other highly-rated sovereigns.

Moody's estimates that Trump's bill will raise the government's deficit by as much as $4 trillion over the next 10 years. To me, that officially reduces DOGE to mere lip service. The cost of government will go up under this president, as it has under every other president.

No matter how much you might like any given White House occupant, they all behave the same way in the end. The only exception in the current administration is Trump's trade policy. We'll have to wait and see how far he gets with it, and how it impacts our lives and finances.

Putting it all together...

Three huge negatives are hanging over the market...

First: The U.S. government is radically reworking its trade policy with every major trading partner (and eventually all the minor ones, too, I'd wager). No matter how good that is for the U.S. economy, it'll require a painful period that will likely cause asset prices to fall.

Second: Trump's big, beautiful bill has only passed the House. It's not a law yet, and we don't know how it'll change in the Senate. So far, it suggests that it doesn't matter who is in the White House. The spending never falls, the debt keeps rising, and the bombs keep dropping (Trump is the fourth U.S. president to bomb Yemen). I had real hopes for DOGE, but it will absolutely not reduce the size of government.

Third: The government has way too much debt, and it's becoming a real problem. The Treasury auction proves that Ray Dalio is right to warn us that there comes a time when a country can issue so much debt that investors simply no longer wish to buy its bonds.

So while there might be significant long-term positive outcomes from the new trade policy or even the big, beautiful bill, the short-term impact is all negative.

You know what to do...

I've said it many times, and I will keep saying it: Prepare, don't predict.

By all means, hang onto your shares of great businesses and let them compound your money at arm's length from the tax man. Also make sure you own some gold and perhaps a little bitcoin as a call option on monetary chaos. And keep plenty of cash on hand to seize opportunities that inevitably crop up in market declines.

But stay disciplined. Sell the lower-quality securities you own. This is no time to hold anything but the highest-quality investments.

That's what I'm doing, and that's what I recommend others do. It will help you preserve your capital and grow it… even as big economic shifts lead to higher market volatility.

New 52-week highs (as of 5/22/25): Alpha Architect 1-3 Month Box Fund (BOXX), Enel (ENLAY), GE Vernova (GEV), K+S (KPLUY), and Rubrik (RBRK).

One housekeeping note before the mail... Our offices and the U.S. markets are closed on Monday for Memorial Day. After this weekend's Masters Series, we'll return with our regular Digest fare on Tuesday. We hope you enjoy the holiday weekend.

In today's mailbag, we have a question about a detail in the proposed tax and spending bill in Congress... Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.

"On television last night, I heard that [the spending and tax bill] contains a restriction on contempt of court charges that could be filed if court orders were ignored. I tried to find it online – they mentioned section 65C – but I got nothing. Do you have any information available to you and if this is true, how would it affect the stock market?" – Subscriber Allan Z.

Corey McLaughlin comment: Thanks for the note, Allan.

So, this is true. The 1,000-plus-page bill passed by the House includes a provision (in Section 70302) that would restrict the federal courts' ability to hold government officials and other litigants in contempt for disobeying their orders.

However, it's unclear if this will pass through the Senate, or whether courts would or could strike it down.

As far as how this would hypothetically affect stocks, it's hard to say. I wouldn't suspect an immediate impact apart from the influence of the entire bill in general, but there would be economic impacts down the road, not to mention significant political and legal impacts.

What comes to mind first is that it could help make various Department of Government Efficiency cuts in government departments (and federal job cuts) stick. It might also play a role in the enforcement of tariffs, whose legality have begun to be debated in the courts.

But frankly, this is mostly political fodder that we really don't care to get into much more here, at least yet, since the bill is not final and probably won't be for another month or so.

Good investing,

Dan Ferris
Medford, Oregon
May 23, 2025