Is A Bear Market Upon Us? It Depends On Where You Look

by: Warrior Economics

Summary

Although we are not currently in an equity bear market, it is very likely that US equities will continue to move downward going forward.

Equity valuations are frothy at this point with CAPE ratio at 24.

Commodities have been on life support for over a year, this is not strictly a supply story and it is indicative of continued economic weakness.

As a prudent investor I am considering maintaining low risk positions, limiting additional allocations to riskier asset classes and writing covered calls on currently owned long term equity positions.

There are a number of theories regarding the origin of the term "bear market". Merriam Webster notes that it was first used in 1858 but offers no details regarding the context of the early use of the term. Common knowledge suggests that the term is derived from the obvious ways bulls and bears attack their respective prey, a bull thrusting upward while a bear will tend to use his paws to swipe downward. Another hypothesis is that the bear market got its name from bear fur traders who would enter contracts to sell furs they did not yet own under the speculative hopes that the value of the commodity would drop. Given the limited information as to the origin of the term I decided to put an end to my fruitless research efforts regarding its genesis.

Luckily a formal definition of the term "bear market" is obvious and generally agreed upon. Generally, most would agree that a bear market is one in which prices are down broadly and market participants continue to anticipate dropping prices. More specifically, most experienced investors would consider an equity bear market to be one in which broad equity indexes have dropped more than 20% from their 52-week peak.

Are US equity markets down 20%? Obviously not but let's run the numbers below so we can frame the discussion.


Based on yesterday's close we are not yet in a classic bear market with respect to any of the major U.S. equity indexes. I am glad we could clear that up rather quickly. However, what about valuations as a possible predictor of future market directions? See the chart below, which was exported from CAPE ratio data produced by Nobel Prize winner and Yale Professor Robert Shiller. As you can see stocks are currently trading at 24 times earnings, down from 26 earlier this month. PE ratios have only been this high on three prior occasions. These time periods are a bit disconcerting as they include 1929, 2000 and 2007. We all know how well those years ended. I want to be clear, I am not implying that this data is predictive of a financial collapse in the near term or at any time. However, this is another data point to be mindful of when asking where equity markets might be heading.

As a side note, you can see that interest rates have consistently followed a downward trend since 1981. This is due to the accommodative Federal Reserve policy of keeping the federal funds rate artificially low for long periods of time. I believe that this has been a major factor in fueling the extreme boom and bust cycles that we have seen over the last 30 years.

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But why are we limiting analysis to stocks? How about other asset classes that are also leading indicators of economic activity?

When we look at commodities there is no question that we are in a major bear market. I will not go down the list of every commodity known to our modern industrial economy. Let's keep the data points to a manageable number by looking at two proven bellwethers of the global economy. Copper and petroleum?

"Dr. Copper" is certainly an important leading indicator of economic activity as it is used in an endless number of industrial applications. A well trained monkey could look at the chart below and come to the conclusion that copper is in bear territory. Clearly, this chart shows copper dropping from its 52-week peak to a spot price of $2.06, a loss of approximately 30%.

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Let's also take a look at crude. It still powers most planes, automobiles and standing armed forces throughout the world's major economies. Therefore, it is a big indicator of economic activity, especially in the context of a slowing Chinese economy and sluggish growth in the U.S. Clearly, at its current spot price at around $33 it is down about 49% from its 52-week high of approximately $65 per barrel.

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I will not address any possible counter points to my copper chart because few TV analysts talk about base metals. Copper is still extremely important but let's set it aside for now. There are three counter arguments that many analysts might use to discount the notable decline in oil as a bellwether of the US economy.

First, these bullish analysts would likely say that the drop in crude oil is primarily a function of oversupply. Although there is a strong supply-side story to the drop in crude, there is also an expectation of weaker demand in China and in the United States. This fact is illustrated by the recent disappointing manufacturing data in China and lower than expected 2015 Q4 GDP growth of 0.7% annualized in the United States. If oil's precipitous drop was just a supply-side story, I suspect that oil would still be priced at $40 to $50 per barrel. It's currently trading in the low $30s. It's important to note that petroleum can be highly volatile and subject to extreme price movement unrelated to fundamental long term economic activity. For example, oil prices could spike in the event of any number of different geopolitical developments, the most likely of which would be a further acceleration of the proxy war in the Middle East which could cause disruption of the flow of oil through the Strait of Hormuz. This scenario along with a million other possible near term, potentially disruptive, geopolitical conflicts would be altogether different from the long term fundamental forces driving the price of oil, all of which are putting downward pressure on the commodity at this time.

Next, some analysts would postulate, rather vaguely, that the US economy is doing reasonably well and that China will have a limited impact on the rest of the world. This is simply not true. I would submit that US companies have gained a great deal of ground over the last few years primarily due to shrewd bottom line growth (cost savings). But there is very little room for increased revenue going forward in the context of a rising interest rate environment. As a result, the argument for increased top line growth and demand in the US is suspect. As for China, it is the second largest economy in the world with a GDP of $10.4 trillion annually. As a comparison, the US at first place with a GDP of $17.4 trillion in and Japan holds the third place spot at a distant $4.6 trillion. So the argument that a hard landing in China will have a nominal impact on the global economy does not seem to have much basis in fact.

Last, some bulls might accuse me of cherry picking assets and time periods. Fair enough, lets add some breadth and depth to my data set so that we may satisfy the diehard bulls. The charts below analyze several commodity indexes over a 5 year period. Buckle up because it is a bit ugly.

First up, the LME index which consists of 6 important industrial metals including copper, aluminum, zinc, lead, nickel and tin. You can see a clear downward slope during the financial crisis in 2008 and a drop more recently over the last two years which has accelerated in recent months.

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Let's broaden things a bit more by looking at the GSCI Commodities Index. It represents commodity futures contracts in over 20 different commodities including agriculture, industrials, energy, precious metals and livestock. You can clearly see a drop in this index. However, it is heavily weighted in the energy sector so to be thorough we will take a look at another index.

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Finally, the chart below illustrates the price movement of the CRB Commodity Index which tracks 19 commodities including aluminum, cocoa, coffee, copper, corn, cotton, crude oil, gold, heating oil, hogs, cattle, natural gas, nickel, orange juice, refined gasoline, silver, soybeans, sugar and wheat. A clear down ward trend seen with this index as well.

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So the question remains. Are we in a bear market? Technically as of January 28, 2016 we are not in an equity bear market but we are close. However, commodities have been in bear market territory for over a year and are indicating continued economic weakness. It is always impossible to predict the timing and degree of stock market declines or recessions. However, in the context of current equity valuations and commodity prices, I can see only a few sensible strategies that I will be contemplating in the near term as a prudent investor. First, I plan to maintain already existing defensive strategies in cash as well as short term high quality bonds. Second, I will be limitting additional allocations to risky asset classes in the near term. Third, I will consider covered calls on some existing positions of high quality common stock and liquid equity ETFs that I plan to hold long term. As market conditions develop in coming months, opportunities in commodities and commodity producers may become appealing deep value stories. However, the economic picture may be a bit too cloudy to take on additional risky positions within a portfolio at this time. It can sometimes pay to be cautious even when there appears to be opportunities to invest in undervalued asset classes. Only time will tell what direction the market will move in but I believe it will pay to be a skeptic in coming months.

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 a publication intended to give general information to the investment community within Seeking Alpha. As such, the article is not rendering individual investment advice based on your personal financial situation. Obviously, it is also not intended to offer any of the securities mentioned in the article for investment. The information in this report has been proofread and every effort has been made to validate the data within the article. However, no representation is made that every data point in this article is correct or error free. If there are errors brought to the attention of the author, an effort will be made to correct them. Furthermore, this article is for informational purposes only regarding general market conditions and basic financial concepts; it is not intended as primary research or individualized advice. You should conduct your own research with the assistance of your own personal qualified investment adviser prior to initiating any investment strategy mentioned in this article. Only you and your personal tax and/or financial adviser can review your individual situation to decide whether or not a strategy or investment is right for your portfolio.