Don't Feed The Bear

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Includes: DIA, EWC, EWD, EWG, EWH, EWI, EWL, EWQ, EWS, EWW, EWY, EWZ, EZA, FXI, IDX, INDY, IWM, IYT, QQQ, RSX, VOO
by: Kevin Wilson

Summary

We appear to be involved in a global cyclical bear market, with confirmed 20% declines in at least 16 countries (e.g., Brazil, Germany, and China).

We may only have covered about half the distance to the bottom in the U.S., assuming we are involved in a cyclical, rather than a secular bear market.

On the way down the "slope of hope" some are willing to trade the rallies, but risk/reward is not good.

Most investors should not "feed the bear" by trading counter-trend rallies, lest they end up getting bitten.

Given that a cyclical bear market is generally (but arbitrarily) defined by a 20% drop, we appear to have entered one, at least for the Russell 2000 (NYSEARCA:IWM) and the Dow Transportation (NYSEARCA:IYT) Indices in the U.S. As this goes to press, we are down only about 12-16% for the other major U.S. indices, but many observers believe that the Russell 2000 and the Transports are leading the market down. The sell-off has been even worse almost everywhere else globally in the last few weeks, with bear markets "officially" beginning or continuing in Brazil (NYSEARCA:EWZ), Russia (NYSEARCA:RSX), China (NYSEARCA:FXI), India (NASDAQ:INDY), Germany (NYSEARCA:EWG), France (NYSEARCA:EWQ), Italy (NYSEARCA:EWI), Sweden (NYSEARCA:EWD), Switzerland (NYSEARCA:EWL), Canada (NYSEARCA:EWC), Mexico (NYSEARCA:EWW), South Korea (NYSEARCA:EWY), Indonesia (NYSEARCA:IDX), Hong Kong (NYSEARCA:EWH), Singapore (NYSEARCA:EWS), South Africa (NYSEARCA:EZA), and a few other countries. Recent evidence of a worsening global economic slowdown has challenged somewhat the widespread belief that the slowing over the last few months was probably transient. Recessions appear to have taken hold during the last year in Russia, Brazil, Canada, and Japan, and may be starting in a few other countries.

Of special concern is the possibility that a so-called hard landing or recession might occur in China. Many observers like Michael Pettis, Jim Rogers, Charles Gave, and John Mauldin think China's economy is still relatively stable however, in spite of recent declines in many measures of economic activity. It may be too early therefore to call for a global recession, but it is also too early to rule one out. The World Bank just lowered their forecast global GDP to 2.90%, which is low but not quite recession territory. Much of the economic slowing in Asia and Latin America can probably be attributed to the huge transition going on in China, as that country tries to move from a dominantly manufacturing economy to a services and consumption-driven economy. But the destructive aftermath of credit bubbles and their associated debt-deflation cycles in China, Japan, Europe, the U.S., and various emerging economies is a major factor as well. Declining population growth in China, Russia, and Japan has not helped, and is a factor in other countries also. Rapidly falling commodity prices have severely impacted economic growth in most producer countries, especially of course in various Asian and Latin American emerging economies, and in much of the Middle East due to lower oil prices.

Returning to the subject of the markets, we have just seen a very sharp counter-trend rally off the low reached on January 20th, 2016, but it seems that the rally may really be a consolidation pattern, since it involves alternating positive and negative 200-point moves. If so, the next significant move is likely down again, since the original market direction does not usually change after a consolidation pattern develops. Many analysts believe, as does famous bearish economist John Hussman, that if this consolidation pattern somehow manages to turn into a rally, this will be only a typical fast, furious and prone-to-failure counter-trend rally which will fail to make a new high, and should normally be used to unload unwanted stocks. Sentiment is strongly negative, as evidenced by various investor and institutional surveys, but enough investors are still bullish that we have likely not hit bottom yet. I would expect the market to drop at least another 12% from the recent low, and possibly more. There are several reasons for this estimate: 1) the average cyclical bear market experiences a 26% drop, so if this is a bear we have a ways to go; 2) sentiment indicators are less negative than they would be if true capitulation had occurred, as in 2011 or 2008; 3) although the market action on the 20th mimicked capitulation with its intraday reversal and double-sized volumes, other measures like the VIX volatility Index did not reach the level normally associated with capitulation, i.e., somewhere above 40; 4) panic selling was limited to just a few hours on the 20th , and did not extend through several daily closes, as one might expect in a true capitulation sell-off; and 5) technical charts suggest a bottom for the S&P 500 in the vicinity of 1500-1567.

The venerable Dow Theory gave a sell signal last week when the Dow Industrials (NYSEARCA:DIA) confirmed the failure of the Dow Transports . Other signs of potential large downside risk come from chart watchers like Brad Lamensdorf and Lance Roberts, both of whom have made a good case that markets will likely drop substantially lower in the next few weeks. If the next sharp dip breaks the critical support level again at 1821-1867, we can probably assume another big down-leg has begun. Others (of course) are buying the dips now based on perceived cheap valuations, and there could be merit in that for those with really strong stomachs and/or a lightning-fast trading finger. As the saying goes though, bear markets slide down a "slope of hope," and by definition each new rally fails to make a new high. If history is any guide then, there will probably be several of these rallies on the way down to an eventual market bottom, as charts develop a "dragon's-tooth" pattern.

Naturally it is important for investors to make the call as to whether this might be a cyclical bear market, or much worse, a secular bear market. We have stated elsewhere that we think the evidence still favors a cyclical bear, so we do not expect a recession even though the global slowdown is substantial. If for the moment we assume that only a cyclical bear is at hand, then our view of the market decline can be a little more technically-oriented, as opposed to macro-oriented. Again, we expect a cumulative drawdown then of about 26% from the highs last May, and that means we've already come down about half-way. Of course we could be wrong, and markets could completely recover without going much lower (as some are hoping), but if we are wrong it will be an amazing departure from most of market history. Indeed, I know of no examples where, based on evolving economic and market data, stock markets first anticipate an increased risk of recession with a year-long topping pattern (including a probable "head-and-shoulders" mega-top), punctuated with three extremely sharp sell-offs, but then somehow go on to reverse and discount it away again a few weeks or months later, with very little positive economic data in support of the change. Even the cyclical bear market that included the 1987 stock crash actually took three months after peaking to reach a bottom, and 18 months to recover, although most of the losses occurred in just two days.

During the "slope of hope" or "dragon's tooth" period, it is tempting to trade the rallies, especially because they can be really strong due to short squeezes and the buy-the-dips mentality that is entrenched after so many years of central bank manipulation of the markets. But in my opinion you risk "feeding the bear" if you play this game. Eventually you will get bitten, and the bigger the bear, the harder the bite. It's common for experienced day-traders and those with algorithm-trading capability to speculate on each leg of the journey, i.e., long on the up-legs, short on the down-legs. But this time there may be a need for a dose of caution by even these speculators, since the risk of a waterfall pattern, or crash, is relatively high, according to a wide range of market analysts. The argument for high risk of a crash is based on certain extremely large divergences and also very poor market internals. For example, the divergence between the Dow Transports and the Dow Industrials is still large, with the former down about 28%, and the latter only about 13%. Likewise the Russell 2000 is down about 23%, whereas the S&P 500 (NYSEARCA:VOO) is down only about 12%. We have data showing that internally, the average mid-cap and larger stock in the New York Composite Index (NYA) is down 28%, but the index itself is only down about 18%. Assuming these divergences and poor internals were resolved rapidly, a crash could possibly be the result.

In addition to these technical factors, the long-term mispricing of risk brought on by central bank interventions, and the high uncertainty due to plummeting oil and other commodity prices, deflationary pressures, potential currency devaluations, a potential credit crisis in China, a potential financial crisis in Italy, massive equity outflows, and significant geopolitical risks may impact the market's sentiment and discounting of risk in unpredictable ways. Add to that the very high valuations, falling profit margins, rising default rates, weak revenue growth, strong dollar, and manufacturing recession in the U.S., and you have some potential for a surprise move. We have already wiped out $4 trillion of gains worldwide, and a sudden step-function type move to lower levels could do a lot more damage. Investors are definitely risk-averse now, so they will tend to sell first and ask questions later. We have already seen margin call activity in the U.S. markets, and a sudden drop would be accentuated by additional margin calls on the approximately $450 billion in margin debt.

Ok, well then what if instead of a cyclical bear market, we are actually about to enter a recession and secular bear market? Historically, the counter-trend rallies in a secular bear market are much bigger in scale than they are in a cyclical bear market. For example, in the 2000-2001 bear market there were five counter-trend rallies, and the largest three were all more than 20% moves on the NASDAQ Composite (NASDAQ:QQQ). Couldn't these be played? Well, let's think through what might have happened if you tried. The first rally to consider was a 24% up-move in April of 2000. It lasted only ten days. Presuming you called it on the second day going both up and down from the pivot points, you would have gained only about 8%, but would have had to trade massively within a six-day window. Some would take that risk, but it's clearly not for everyone. The second rally was a 35% up-move that began in May 2000 and lasted 34 days. In this case the net gain cleared under the assumptions above would have been about 29%. This is more like it, but of course you could have had no idea in advance that this move would be different than the previous one. The final rally considered here was a 21% up-move starting in August 2000, and lasting 19 days. The net gain under the assumptions above was about 13%.

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Here's the other side of the question though: if these were the potential rewards, what were the risks? The drop after the first rally was about 21%; after the second rally the drop was about 18%, and the drop after the third rally was about 29%. Adding all of this up, you could have gained a cumulative reward with perfect execution of about 50% under the assumptions used, but your downside risk was a cumulative 68%. Again, there are people who can do this, but many more who can't. It is also important to note that the weekly MACD, RSI, and Williams %R signals never reversed enough during these rallies to help with a decision, so you would have had to use shorter-term momentum signals and careful studies of candlestick indicators, etc., to make the calls.

We are eagerly anticipating cheaper valuations after the prospective bottom of the current presumed bear market is reached, with average P/E ratios much lower than the current 17, and cheap prices based on other parameters such as price/book value or price/cash flow. However, most investors would be wise in this situation to focus on gradually buying into a higher equity allocation over a period of time bracketing the bottom, when clear bargains are visible. Right now it seems likely that good performance will be found in large cap value stocks with clean balance sheets, low debt, high cash levels, and strong dividends. The opportunity to buy great stocks at reasonably cheap prices will come, and those who look for opportunity amidst the fear will be rewarded in the long run. Those who want to can play the game of "feed the bear," but plenty of money can be made without taking such risks, allocating defensively on the way down, and investing decisively in equities when valuations and sentiment look better.

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.

Additional disclosure: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended.