Is This a New Bear Market?
May 31, 2010
With the S&P 500 falling -8.2% this month, perhaps the best advice any investor could have heeded so far this year was to “sell in May and go away.” And in light of the fact that at its low point last week the market had fallen -12.3% on a closing basis and -14.6% on an intraday basis, many investors are now wondering if this is the beginning of a new bear market and/or a replay of the 2007-08 crisis.
To be sure, this market has put fear back into investors’ vocabulary. If the doomsday scenario of Europe’s debt mess dragging the globe back into recession isn’t enough to get your attention, the out-of-the-blue ‘flash crash’ which saw the DJIA plunge nearly 1,000 points in twenty minutes probably did. But while fear is indeed on the rise, should we really expect to see the market morph into another bear?
To hear the glass-is-half-empty gang tell it, the fact that we’re seeing the biggest pullback since the bull began on March 10, 2009 is meaningful. Up until late April, the bulls had been large and in charge with nary a single selloff reaching the all-important -10% mark for more than a year. But with the current decline reaching double digits and the 200-day moving average now looking like a resistance zone, our furry friends suggest that it is only a matter of time before we see the market begin to head south again in earnest.
The bears point to the action across the pond as the culprit for what they expect will be their return to prominence. The idea is that the debt mess will, at the very least, create an economic slowdown, which will spread to China, then the U.S. and beyond. As such, the bears contend that stocks are now currently overvalued and must be adjusted downward. Exhibits A, B, C, and D in the bear case are: the tightening credit conditions, the plunge in the Euro, the failed European auctions, and the flight to quality via the dive seen in U.S. interest rates
Speaking of U.S. rates, it was the fear of what could happen next overseas that pushed the yield on the 10-year Treasury Note down to its lowest level since the credit crisis ended during the middle of last week. Fear also has caused credit spreads to widen to, yep; you guessed it, the highest levels since the post-Lehman days.
Moving a little farther east, the naysayers have been telling anyone that will listen that China’s growth story is about to come to a screeching halt. The most common arguments here involve the moves by the government to try and avoid a bubble in real estate and the impact of a European slowdown on China’s export-driven economy.
The bear camp also argues that the price of oil and the current malaise in investor sentiment are reasons to be concerned about more downside action. With oil gushing into the gulf on an ongoing basis and with no end in sight, one might have expected to see crude prices rising. However, the fear of economic slowdown has pushed the price of oil to its lowest level since early 2009 – a time when everyone thought the sky was falling.
Finally, our friends in fur suggest that big hedge funds and institutional investors have had a change of heart about the future of stocks and are now “de-risking” en masse; something that will cause rallies to be sold into with a vengeance for many months to come.
Is It Different This Time?
While the above arguments are enough to give any sane investor pause, we’re going to go the other way for a few minutes this morning and try to counter the arguments for a second coming of the big bad bear.
For starters, we need to understand that although the storyline of debt problems and credit tightening sound eerily familiar, the overall situation now is nothing like what we saw in mid-2007 and 2008. The exhibits for our case include the state of the economy, earnings, and credit conditions, as well as the internal health of the stock market itself.
Looking first at the current economic conditions and what could come next, we first need to remember that in 2007/08, the economy was entering into recession; a slowdown that has since become known as The Great Recession. However, today is a very different story. The U.S. economy is in an expansion mode and even the job market is on the cusp of gaining traction.
In fact, the economic model we follow has just moved up into the “strong growth” mode. While this may run counter to popular opinion at the present time, we will suggest to those raising an eyebrow consider that “strong” is a relative term here. Regardless of whether or not we can agree on semantics, the bottom line is the model projects a gain per annum in the stock market that is double that which occurs when the economic model is in a moderately positive mode and more than double the buy-and-hold approach to the stock market since 1947.
Next up, let’s take a peek at credit conditions. While there is no denying that credit has indeed tightened up noticeably over the past month, swap spreads, TED spreads, and LIBOR rates are all WELL below the levels seen pre- and post-crisis (read Lehman’s failure).
Yes, this is indeed something to watch and no, the rise in these spreads is not a good sign. However, the key takeaway is that the current levels are not indicating that a severe bear market is imminent.
The bears are also doing a lot of jawing right now about the state of corporate earnings. In 2007, earnings were falling and they continued to dive for nearly 2 years. However, at the present time, the earnings line is diametrically opposed. The bottom line here is that earnings are growing quite strongly. And the computers at Ned Davis Research tell us that in this environment, the S&P 500 has gained ground at a rate of nearly 20% per year.
While our furry friends do concede that the first quarter’s earnings parade was a thing of beauty, they contend that earnings gains are about to come to a screeching halt. However, at this stage, this is merely speculation. Thus, until we actually see some signs of an earnings slowdown, it might be best to stick with what IS happening instead of what MIGHT BE happening
Finally, we will compare and contrast the internal action of the market itself to that seen before the bears began to attack portfolio values in 2008. Cutting to the chase, in early 2008, the vast majority of the world’s stock markets (97% to be exact) were below their 200-day moving averages, which themselves were falling. Research, as well as recent history, confirms that when a market crosses below a falling 200-day ma, it usually leads to more red ink.
However, today’s picture is almost the exact opposite as 42 of the world’s 44 major stock markets are currently above their RISING 200-day moving averages. As we’ve detailed in the past, a move below a rising 200-day is actually a long-term buy signal.
In addition, the breadth of the market was less than inspiring by the time the calendar flipped to 2008. But, as you might suspect by now, the breadth of the current market is actually quite strong. Recall that we’ve had multiple “breadth surge” buy signals, with the most recent one occurring just recently, which have VERY strong records and point to higher stock prices one year out.
The Bottom Line: Not Pretty, But No Bear
Our bottom-line analysis of the current double-digit decline in stock prices is as follows. While the action is not pretty at the present time and there may indeed be some additional downside ahead, we believe (a) the action is being driven by fear and not reality and (b) the risk/reward factors favor the bulls at the present time (don’t forget, a 14% decline discounts an awful lot of potentially bad stuff).
We are also of the mind that the debt mess in Europe is unlikely to create anything more than a modest slowdown in some economies. So, with the market in an oversold condition, the negative sentiment so thick you can cut it with a knife, and most of the worries well known at this stage, we’re of the mind that it might be best to lean the other way if you have a 6-9 month timeframe.
However, should the economic indicators start to weaken either here at home, in Europe, or in China, we’ll be happy to admit we were wrong and play that hand from a defensive position. Remember, we like play the game according to what IS happening and not based on what we think might happen.
So, for now, look for a bounce. But don’t forget to watch the economic data very closely – and keep your portfolio nimble enough to react to just about anything.
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