Bill Cara

Bear Market Tendencies

The U.S. equity markets are on pace for their worst month since February 2009, at the depths of the Financial Crisis. For those who have argued over the past years that markets are broken, this is just more proof. Very ittle has changed with the economic fundamentals since September. So why a -20% correction in the majority of S&P 500 stocks? A Trade War that should have been priced-in for months? Federal Reserve rate hikes that began in 2015? The no-deal resolution of Brexit? We see this move as almost purely technical. In 2018 the steady up-trend in equities from 2016 was broken. Technicians call this a topping pattern. October’s swift decline in prices broken support levels and turned moving averages on the indexes down. In any case, this is the inevitable conclusion of an asset price bubble. Now investors must determine if we are now in a prolonged bear market or a rapid 2011-syyle bear-market/correction. In this week’s Commentary, we look at possible paths the equity bear market may take.

The big news this week on the macroeconomic front was the decision by the Federal Reserve to go ahead with the 25 bp rate hike at their December meeting. Markets were hoping for a more dovish tone from Jerome Powell at the press conference. The only concession made by the Fed in light of the market turbulence was to reduce the number of expected rate hikes in 2019 from 3 to 2. In a correction, all news is bad, so markets tumbled more post-Fed. Media and market pundits blamed the Fed for this week’s chaos. The Fed’s error was not made this week. The error was leaving rates at 0% for 9-years. Now investors will collectively pay the price. As for macro data, the Fed’s preferred PCE inflation measure came in at +0.1% for November, below consensus for
+0.2% (1.8% y/y). Inflation worries seem to be a secondary concern in the world today. The Fed must have had this number before Wednesday’s rate hike….and they hiked anyway. Again, this raises doubt that we’ll see any more rate hikes in 2019. The final look at Q3 U.S. GDP came in at 3.4% (vs 3.5% expected). The LEIs rose 0.2% in November vs forecasts for unchanged. The Housing data was mixed. Building Permits came out at 1.33 million in November (vs 1.26 M expected) and Housing Starts at 1.26M (vs 1.23 M expected). But the NAHB Housing Index slipped to 56 in December from 60 the prior month and 61 expected. In sum, macro statistics can not be blamed for the equity selling in December.

Bear Market Tendencies

Now that it’s safe to declare the October-December sell-off a Bear Market (Russell 3000 has fallen -18.3%), we thought it might be useful to get perspective on how the previous three bear markets this century unfolded. While obviously the path of each bear market is unique, we are betting a common pattern will play out again this time: a jagged sell-off in the initial phases, a strong counter-trend up-cycle, followed by a capitulation phase at the end of the bear market (during which the greatest losses are seen).

Tech Bubble Bear Market of 2000

We are not interested in the reasons/causes for each bear market wave in this Commentary, but rather just the chart patterns. In 2000, we observed an initial equity dump, Wave 1, which may be akin to this year’s October drop. The next phases (Waves 2, 3, and 4) are similar in amplitude and duration to the choppy November market this year. Finally, following Wave 4, we see another big wave down (unlabeled, from about 1390 to 1100 on the S&P 500, or -20.8%). The bad news is that if today’s bear market is taking this same pattern as 2000, we are in this fifth wave down now. The good news is that it is unlikely that we’re going direct to the bear market bottom. The over +18% counter-trend rally from 1100 to 1400 rewarded patient investors who did not sell into panic (provide that they took action in the rally to lighten up more).

Financial Crisis of 2008-2009

From the market top in 2007 we again see the multiple wave pattern in a jagged down-trend. If we make comparisons, Wave 1 with initial losses of -10% looks a lot like October 2018. Wave 2 (with a little intermediary dip) looks like price action in November 2018. Finally, the steeper Wave 3 down (-15.9%) feels like what we are going through this December. The good news again is that we are most likely to see at least one large counter-trend rally up (like Wave 4 or Wave 6 below), for those who are feeling a little less bullish suddenly.

Mid-Cycle Bear of 2011

We count 2011 as a bear market, even if most don’t. The Russell 2000 fell over 20% and the S&P 500 fell – 19.9% (we round up!). This 2011 scenario is still a possibility – a sharp wipe-out in an on-going bull market. While we believe that we are currently in a 2000 or 2007 scenario, we must not be dogmatic if somehow the S&P 500 (SPY) manages to get back above 2820. Wave 1 below would be like this October’s drop and Wave 3 would be the larger drop that we are now experiencing. If the S&P 500 quickly gets above the former support (now resistance) level of 2600, we would be more open to considering the 2011-style, one-big-drop-and-done bear market.

Everything Bubble Bear Market of 2018

We labeled each wave since October however the general pattern of 2000 and 2007 is there: a decent size initial wave down, a bit of sideways back-and-forth consolidation, then a bigger wave (Wave 7 below) down. In terms of both duration and magnitude, we may have further to fall on the S&P 500 until we get the counter-trend upcycle. Depending on the reader’s appetite for risk and objectives, it may not be wise to get out after the nearly -13% move since the 3rd of December. Understandably, most readers want to get out. However, after a possible +13.5% move higher (like Wave 6 higher form 2008), these same readers will be wanting to get back in.

Conclusion

Although most investors were expecting buy-the-dip not to work at some point, the market drop since October has caught most off-guard. The move down was mostly technical in nature (fundamentals are little changed since September) and most losses came in December, which traditionally has been the strongest month of the year. Our message in this Commentary is (1) we are more likely in a bear market that will be longer and deeper than that of 2011, and (2) panicking and selling out at this point on the current wave down is mostly likely a sub-optimal strategy. The severe losses in a bear market come at the very end. And in the interim at least one large tradable rally should take place.