Most Stocks Are Already in a Bear Market

The S&P 500 is near its highs, but most of the market is not. Nearly six in 10 American stocks are down more than 20% from their highs. That decline meets the technical definition of a bear market. The index's gains mask this weakness.

The pattern is sharper among chip makers, which sit at the center of the artificial intelligence (AI) trade:

• Nine in 10 chip stocks are down more than 20%.
• Four in 10 have lost half their value.

Why the Index Looks Stronger Than the Market

The S&P 500 is now driven by a small group of large technology companies. Seven or eight companies account for most of the index's value. The rest of the constituents have moved far less.

An investor who holds an index fund therefore owns a narrow group of stocks that tend to move together. This concentration creates risk. A setback at one of these companies could affect the entire index.

Historical Context for Market Declines

Market declines of this kind do not necessarily signal a market top. A top typically occurs when most stocks rise together and investors show little concern. The current pattern is different. Most of the market's losses have already occurred.

The Midterm Election Pattern

The S&P 500 has averaged a 16% return in the 12 months after midterm elections. About 14 percentage points of that return came in the first six months. The index has finished higher after every midterm election over roughly the past 50 years.

Two mechanisms are cited:

1. Spending. Each election period tends to increase government spending. Part of that spending flows into the economy and eventually into equity prices.
2. Resolution of uncertainty. Investors often hold cash and delay decisions before an election. Once the vote concludes, that capital tends to re-enter the market.

The Money Moves Before the Economy

Equity markets respond to expected corporate earnings and liquidity. Wages, consumer prices, and employment respond later. The analysis therefore focuses on the direction of capital flows rather than on current economic data.

Three Factors Converging

1. Digestion of AI Investment

Large technology companies have spent hundreds of billions of dollars on AI over the past two years. Investors have questioned whether this spending will produce adequate returns and how it is financed. This uncertainty has driven much of the recent decline.

Large infrastructure investment cycles typically follow a similar sequence:

• Capital flows into a new technology.
• Firms overbuild capacity.
• Investor sentiment turns negative, and weaker participants exit.
• Companies that survive capture the long-term gains.

The analysis cites railways, electricity, and the internet as precedents. The internet's collapse in 2000 eliminated weak business models, but leading internet companies later grew into dominant firms. The analysis argues that AI is in the shakeout phase. The risk now appears largely reflected in prices.

2. Clearing of Midterm Uncertainty

The midterm elections remove a source of uncertainty. Markets tend to respond positively when that uncertainty ends, regardless of the outcome.

3. Expansion of Money Supply

The following developments are cited:

• The M2 money supply is growing at its fastest pace in four years. M2 measures money in circulation and in readily accessible deposit accounts.
• The central bank has stopped reducing its balance sheet.
• The central bank has resumed purchases of government debt, adding liquidity to short-term debt markets.

The analysis states that this expansion typically moves into equities and into hard assets that hold value during currency depreciation.

Where Institutional Capital Tends to Flow

Institutional investors follow capital flows and generally operate under defined rules rather than long-term, unconditional holdings. When liquidity expands, the analysis expects capital to favor two groups:

• Quality companies with growing sales, growing profits, and solid returns on capital.
• Companies with compelling narratives that attract broad demand.

The analysis notes that institutional buyers often purchase stocks in which other institutional investors are also buying. Institutional flows are therefore a useful indicator of where demand is concentrating.

Investor Sentiment as a Contrarian Indicator

The American Association of Individual Investors (AAII) surveys investors on whether they expect the market to be higher or lower in six months. Since the survey began in the 1980s, an average of 31% of respondents have expected a lower market.

Readings have exceeded that average at key points:

The analysis argues that extreme pessimism often precedes market gains. Investors who have already sold leave fewer sellers and more available cash, which can support prices.

Economic Data and Market Performance

The analysis contends that the stock market does not measure current economic conditions. Two examples are cited:

• 2020: Unemployment reached 15%, the highest level since the Great Depression. By August, the market had reached an all-time high. Monetary expansion directed liquidity into equities.
• 2022: Unemployment fell to a 50-year low, but the market declined 19%. Liquidity was being withdrawn during this period.

In 2023, many experts forecast a recession that did not occur. The market had one of its best years in a decade.

Practical Considerations

The analysis offers two observations:

1. Holding a large cash position may reduce purchasing power if monetary expansion lifts asset prices.
2. Investors should focus on capital flows rather than on headline economic news when assessing market direction.

The authors are not registered or licensed financial advisers. The analysis does not constitute personalized investment advice.

Summary

• Most U.S. stocks have fallen more than 20% from their highs, while the S&P 500 is supported by seven or eight large technology companies.
• The S&P 500 has finished higher in the 12 months following every midterm election over roughly 50 years, averaging a 16% return.
• Three factors are converging: the digestion of AI investment, the resolution of midterm uncertainty, and an expansion of money supply.
• Investor pessimism has historically preceded market gains.
• The analysis identifies capital flows, not current economic conditions, as the primary driver of near-term market direction.