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What if There's a Bear Market in 2012?

Most investment bank analysts and strategists are calling for the benchmark Standard & Poor's 500 Index to rise in 2012, rebounding from a near-bear market earlier this year.

And investors want to be rid of 2011 after record volatility caused a seesaw ride that had stocks alternately soaring and diving day after day.

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Darrell Gulin | Stone | Getty Images

But instead of a 20 percent rally that Deutsche Bank strategists are predicting, what if the U.S. stock market fell just as much next year? Based on Wednesday's closing price of 1249, a bear-market decline would drop the S&P 500 to almost exactly 1000, a level not seen since the summer of 2009.

Among strategists at major Wall Street banks, Deutsche Bank is the most optimistic about the S&P 500's performance, calling for the index to hit 1500 a year from now. Nine other banks, including Citigroup and JPMorgan, also have high expectations.

But those bullish views may be overblown.

"Most people on the sell-side of the Street are paid to be bullish," said Mark Travis, president of Jacksonville, Fla.-based Intrepid Capital. "That's generally what you're going to get from them. For years, I used to catcall the prognostications from Wall Street."

Still, a 20 percent drop next year would be the worst performance since 2008, when the global financial crisis struck. It would take a cataclysmic event — such as the unraveling of Europe, a recession in key emerging markets or war — for stocks to fall into a bear market. After all, corporate profit margins are big and borrowing costs at record lows, conditions that are ripe for earnings growth.

Each of the five investment managers interviewed for this article said that while a 20 percent correction in the coming year is plausible, it's not likely.

"You don't normally have back-to-back recessionary corrections in one year," James Dailey, a portfolio manager with Harrisburg, Pa.-based TEAM Financial, pointed out. "Our base case is that, unlike 2008, we've having a normal cyclical bear market. It doesn't mean it has to be an end of the world recession or depression."

But, then again, the rebound widely forecast in 2011 never occurred, making a fool of star investment managers including Pimco's Bill Gross, and even the Federal Reserve's Ben Bernanke made a wrong call on the direction of the economy.

Dailey said the stock market drop triggered in August after the debt-ceiling negotiations in Congress and subsequent downgrade of U.S. debt by Standard & Poor's "was interesting because it was such a violent crash and we got down to 1,000 so quickly without an accompanying banking system shock or major crisis."

That should make investors wonder how tough the investing environment will get if there's a major shock to the bank system.

The potential for being wrong makes this not an exercise in futility but a good lesson in risk management. Before getting to the ramifications of a 20 percent drop in equity prices in 2012, it's important to figure out what could trigger a bear market. The easy answer is the European debt contagion, which shows no sign of abating. This crisis, most of the investment managers argue, could be the catalyst for a decline in equities next year.

"The debt crisis that we have today around the world is a far more serious situation than it was in 2008," said Steve Hammers, chief investment officer of Compass Advisory Group. "Today, it's so different. The sovereign bubble has gotten so big, it'll be too hard to handle. If the S&P 500 declines next year, it will undoubtedly be because of the debt crisis."

Robert Pavlik, the New York-based chief market strategist with Banyan Partners, said the market could be dealt a massive shock if the euro-zone countries don't ratify whatever proposal is offered. That could push Europe into a steep slide, economically and fiscally.

"The euro will tumble and no one will be out there supporting it. It will drag down Asia, which is where most of their order flow is going," Pavlik said of the most possible scenario. "That could initiate some type of cataclysmic event. That's not even trying to forecast a bomb dropped on South Korea from North Korea or some type of situation in the Middle Eastern countries."

Tom Villalta, chief investment officer with Austin, Texas-based Jones Villalta Asset Management, says that a 20 percent drop would have to be predicated on unemployment rising and some sort of bank run in Europe. "There is credence to this negative feedback loop idea," he added. "The market is not running on fundamentals of companies. It's running on a macro, psychological aspect. The volatility increases in those situations."

TEAM Asset's Dailey says there is the risk that a shock to the system comes early in 2012 and the government doesn't respond quickly enough. This scenario could play out if the cheery economic reports of late sour.

"This current euphoria over decoupling and not having a recession will be squashed. We think the economy is already in a recession," Dailey said. "If the government did not respond and stayed behind the curve by buying into the argument that we'll decouple and avoid recession, a shock to the system could create a deeper, more prolonged recession."

Hammers agrees that this could play out once the holiday season wraps up and investors come back and realize how sluggish economic growth has been.

"I want to be optimistic, but you can't be optimistic when you've had a stock market bubble, a real estate bubble, and we're getting close to a sovereign debt bubble and a currency bubble," Hammers said. "Investors don't want to go through 2008 again. You'll see a mass exodus from the market."

Even some of the larger investment banks are starting to realize the possibility and impact of a huge hit to equities in 2012. Earlier this month, Morgan Stanley said in its 2012 outlook that the base case is that Europe integrates better and the U.S. continues to extend stimulus support. Without those policy moves, however, Morgan Stanley's bear case is a full-blown recession across the globe.

"In fact, even our bear case may still be too optimistic," Morgan Stanley strategists wrote on Dec. 15. "To be sure, we still view this as a tail event, even though the tail has become fatter recently. Putting numbers for GDP and other economic indicators to such a scenario is extremely difficult. Yet, the Great Recession that followed the Lehman bankruptcy would probably pale in comparison to a scenario involving a euro break-up and widespread bank and government failures."

The ramifications of a 20 percent drop are easy to outline: Investor confidence drops, U.S. equity mutual funds see exaggerated outflows once again, the political environment becomes far more tense and acrimonious in an important election year, rates get pushed down further as investors pile into bonds again, unemployment rises, and more intervention by the Federal Reserve, among other possible outcomes.

"Another pullback of that magnitude would have a sizeable impact on people's consumption," Villalta said. "They'll feel the need to replenish the money into their liquid accounts. That's the big risk to me. It'd be a huge change in consumption patterns. Feedback loops play an extraordinary role that create the bubbles and the rapid drops."

The market strategists I interviewed had varying thoughts on what the Fed would do in a situation where equity prices fall 20 percent. Banyan Partners' Pavlik doesn't think it would warrant another round of quantitative easing, although he says the Fed could take over steps to help stabilize Europe like the recent currency swap.

"But it's not a liquidity issue, it's a solvency issue," Pavlik reminds us.

Villalta argued that rates don't have much lower to go, which leads to grand ideas for a QE3 program to boost asset prices.

"That'd be a hard political sell. I'm not sure if the currency is there," he said.

When it comes to the 2012 presidential election, Intrepid's Travis notes that a 20 percent drop would have huge ramifications because of the old adage that people vote with their wallets.

"The year 2008 hasn't faded from memory," he said. "If you get a substantial drop in equity prices, you could have very broad political ramifications because there is certainly some fatigue."

Hammers noted that market returns are usually positive in election years, but 2012 won't be like any we've seen before, which makes it hard to handicap the presidential race.

"The question is, who will make next year's market better? You'll still see a lot of volatility," he said. "It's going to be like the end of 2011."

For investors, another collapse in 2012 could mean that many throw in the towel on the stock market. Since the start of May, U.S. equity mutual funds have shed $120 billion, according to the latest data from research firm TrimTabs. For perspective, the annual outflow in 2008 during the height of the financial crisis totaled $162.4 billion.

"We've had year after year after year of withdrawals from domestic equity mutual funds," Villalta says. "You're still seeing reverberations from 2008 still playing out. The volatile environment had such an impact on the psyche of investors. If we had a drop again, you'd see people continue to pull back more and more and move into bond funds."

Villalta said investors have turned extraordinarily risk-averse after 2008 and 2009. Another drop in 2012 could result in a generational change in investing and spending habits.

"People's own sense of security is predicated on their earning ability, their assets and their real estate holdings," he says. "They play a huge role in their underlying worth. When you have one of those take a huge hit, people have to work harder and save more in order to fill that void."

Intrepid's Travis, though, offers some solace to investors in the event another bear market drop occurs in 2012: Keep looking ahead and don't get caught up in the panic.

"For the individual investor, you have to think across the valley to the next mountain," he said. "When you have rates manipulated to where they are and Treasuries as return-free risk, people are going to have to think past the next blip in the equity market. People are going to have to become comfortable, cover their eyes and jump in."

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TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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