Will We Enter A Bear Market?

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Includes: DIA, SPY
by: Michael Bryant

Summary

The recent plunge took the market into correction territory again.

The yield curve, price-to-earnings, GDP data, and global liquidity seems to say we will not enter a bear market.

Politics, however, says we could enter a bear market.

S&P 500

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Source: Yahoo Finance

Dow Jones Industrial Average

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Source: Yahoo Finance

Has the stock market bounced off a bottom, and should investors jump back into stocks? The above graph of the S&P 500 and the Dow looks like we have bounced off of a bottom. For the third time in the last year and a half, the S&P 500 has plunged down to about the same level, only to bounce back up. The recent plunge took the index down 12.7% from its highs. Meanwhile, the Dow has almost reached its lows from August 2015. The recent plunge took the index down 13.9% from its highs. This would be correction territory, while a bear market is a decline of 20% or more. But could we go lower? Could we enter a bear market?

The above linked business insider article also mentions that "of the 44 previous declines of at least 10%, 19 became bear markets." It also notes that, "Since 1878, any bull market lasting 4 years or more, has turned into a bear market only when the business cycle ends as best evidenced by an inverted long-term (30Y vs 10Y) yield curve." So is the business cycle ending? And has the 30-year vs 10-year yield curve inverted?

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Source: Daily Treasury Yield Curve Rates

An inverted yield curve is "an interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality." Where the green and orange lines intersect, the yield curve inverted. The red line is the 30-year treasury yield minus the 10-year treasury yield. Three out of the four inverted yield curves predicted a market decline, as shown by the graph of the S&P 500. U.S. bear markets occurred from 1990-1992, 2000-2002, and 2007-2009. All three bear markets were predicted by an inverted yield curve. Will an inverted yield curve occur in the near future? Based on where the red line is, no. And thus a bear market probably would not happen in the near future.

Below is a graph which shows the inverted yield curve and a recession.

Source: Forecasting the 2016 election economy

As the above linked article states, "No recession in the last 50 years has started without an inversion in the yield curve." Thus, it does not look like we are heading to a recession.

The business cycle is "the downward and upward movement of gross domestic product ((NYSE:GDP)) around its long-term growth trend." From the bar chart of the quarter to quarter growth in U.S. real GDP, it looks like we are heading to or are at a trough in the business cycle. This is probably already baked into stock prices. Further, after the trough in the business cycle, the real GDP growth will start to tick higher, justifying higher stock prices.

Source: U.S. Bureau of Economics

Also notice that troughs in the S&P 500 happened five of the six times before lower real GDP numbers came out. On December 22, 2015, the Bureau of Economic Analysis estimated that third quarter real GDP growth was 2.0% annually, down from 3.9% annually in the second quarter. This real GDP growth was much better than their original third quarter estimate they made in October, saying that real GDP only grew 1.5% annually despite consumer spending rising 3.2% annually. Analysts had expected 1.6% growth. So the plunge in the stock market should have been no surprise.

Now what about real GDP growth in the fourth quarter? On January 4, 2016, the Wall Street Journal noted that the "Institute for Supply Management, a group of purchasing managers, said that its gauge of manufacturing activity fell to 48.2 last month from 48.6 in November. A reading below 50 indicates the sector is contracting." Further, the Journal noted that this was the "lowest since the end of the recession and marks the first time since 2009 for consecutive months in contraction territory." Then on January 20, the GDPNow model forecasted for fourth quarter real GDP growth was 0.7%, up from 0.6% predicted on January 15. Based on this model, the fourth quarter real GDP growth was a large drop from 2.0% real GDP growth in the third quarter.

It is interesting that the recent big plunge in the S&P 500 started on December 29 at 2078. The most recent bottom was 1869 on January 20. So we can assume that the plunge and the bottom were partly if not largely due to the two releases of the third and predicted fourth quarter real GDP growth. That plunge was 206 points (10.1%) from December 29 to January 20. But such a large drop happened before in 2012 and 2014. The 2012 and 2014 plunges were 9.2% and 6.0% respectively. Thus, we could have hit bottom again.

Bear markets are usually caused by:

  1. Too high PE ratios
  2. An economic downturn
  3. Major political shifts

While there is obviously an economic downturn, it probably would not cause a bear market. In my August 25, 2015 article, I mention that the mean PE ratio of the market is 15.55. The market PE ratio is now 19.96. This number is higher than the mean, and slightly higher than 19.86 which is where the market PE ratio was on August 25, the bottom for last year's correction. From the table below, the S&P 500's forward PE is 15.38, which is about the mean PE ratio. The Dow Transportation actually has the cheapest PE ratio at 11.55. All indexes have lower forward PE ratios than trailing PE ratios, so analysts see earnings growing. The only index to be worried about is the Russell 2000. But while the trailing PE ratio is high at 107.00, the forward PE ratio is low at 14.87.

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Source: P/Es & Yields on Major Indexes

Will a major political shift cause a bear market? The Presidential election is on November 8, 2016. Whether politics will cause a bear market is hard to predict, but the Presidential Cycle says that "U.S. stock markets are weakest in the year following the election of a new U.S. president." Over the last 100 years, the final three, six, nine, and twelve months of a President's last year saw an average gain in the Dow of about 2%, 4%, -1%, and 1% respectively. According to the theory, since the S&P 500 fell about 10% in the month of January, the S&P 500 could rise 11% in the next two months. In the three months after that, the S&P 500 could fall 1% before surging the last six months of the year.

Another theory says that "the end of a two-term president is usually bad news for the stock market." The stock market has already been bad, but can it get worse? Looking just at the S&P 500 performance, the Nixon and Bush years look very similar. Ford/Carter saw a rally, and so has Obama. Thus, will we see a bond shock like in the beginning of Reagan's term? Junk bonds already seem to be in a crisis. During the bond shock of the 1980s, the S&P 500 fell 19.8%. If this theory is true and that we will see a bond shock, the S&P 500 could fall another 7-8%.

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Source: Business Insider

Finally, "crises are preceded by a noticeable change in global liquidity, which refers to the supply of convertible currencies created by major industrial countries and the flow of this capital across borders." As seen in the graph below, the 2008-2009 Credit Crisis and the recent downturn in the stock market corresponded with a plunge in the year over year change in reserves of developed and developing markets. While, both have plunged recently, it looks like both may rise soon, causing stock prices to rise.

Source: Global Liquidity

Conclusion

Most of the data seems to show that there will not be a bear market and that stock prices would rise soon. Politics is the wild card, and it seems to be pointing to a downturn in the near future.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.