Presidential Election Year Bear Markets And 2016

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Includes: EPS, IVV, LLSP, RSP, RWL, RYARX, S, SDS, SFLA, SH, SPLX, SPUU, SPXL, SPXS, SPXU, SPY, SSO, UPRO, VFINX, VOO
by: Paul Wong

Summary

Reduced liquidity leads to the rise in high yield interest rates and more debt defaults.

Poor economic growth outlook lowers future earnings.

Many foreign stock markets are already in bear territory, may pull US market down.

Election anxieties and political uncertainties may force investors to the sideline.

Paul Wong 01/29/2016

The last two US bear markets coincide closely with the Presidential Election years of 2000 and 2008. The eight-year cycle comes around again in 2016 as we ponder the possibility of another market downturn. The circumstances that caused the previous bear markets were quite different, but the financial damage and pain experienced by individuals were the same. Identifying and understanding the reasons that led to the collapses and evaluating the current issues this year will help us better in preparing for the next bear market.

Year 2000, the 'dot-com' bear market was built upon 6 years of rising stock prices due to the internet technology euphoria and low oil prices. Y2K proved to be a non-event but the eventual bursting of the dot-com bubble was very real. The market peaked in March 2000, fluctuated until September with a lower high before the election, then fell for a loss of 49% peak to trough for a period of 31 months overall.

Figure 1

Year 2008, the 'financial crisis' bear market climaxed on 5 years of rising stocks due to low interest rates, easy credit and relaxed regulations to encourage home buying that led to overrated and volatile bonds and debt instruments. The market peaked in October 2007 before heading down. Two months before the election in September 2008, the financial market collapsed featuring a fast and furious downturn severely impacting both the stock and bond markets. Thanks to the Fed's action and the launch of Quantitative Easing (QE), the market finally stabilized. The stock market bottomed in March 2009, only 4 months after the election for a 17-month duration peak to trough with a drop of 57%.

Figure 2

The 2008 event was equivalent to a financial earthquake. Excessive speculation by over-leveraging debt on shaky collateral built up stress that triggered the financial system to become unhinged. The ripple effects traumatized investors around the world. Today, the increasing total debt load encouraged by QE exerts the same stress to the world financial system. The smart way to alleviate the stress is by lowering the debt levels and halting QE to prevent the system from becoming too strained. Otherwise, the inevitable consequence will come in the form of multiple small or a single large earthquake to the financial world as highlighted above. Lessons from nature are the best way to learn the truth about the real world. Laws of nature do not lie.

Presidential Election Year of 2016 and Possibility of Another Bear Market

The stock market has recovered from the bottom in 2009 and gained about 180% in 7 years resulting in one of the best and longest bull market. However, the rise may have created room to fall unless supported by a strong economy with corporate earnings growth.

$SPX - SP500 Index

Figure 3

Comparison of the past 2 Presidential Election bear market cycles can offer insights to the future stock price ratio outlook for the upcoming election in November 2016. Price ratio for each period is the monthly price divided by the starting month's price, so the starting point is always 1.00. So far, the current stock price ratio tracks between the 2 previous cycles but has stayed closer to the 2008 cycle both in magnitude and timing. Tracking the 2008 trend further may suggest more downside towards a bear market before the Election Day. The past cycles provide a good reference to gauge future price movement.

Figure 4

The historic and coordinated global launches of QE among major central banks in 2008 stopped the fall of the markets. The consensus tool used was printing money; central bank balance sheets have increased more than twofold from $7 to $17 Trillion since then. The liquidity injection in the form of easy debt with low interest rates from the central banks went through commercial banks to the economy as loans. The elevated lending has led to robust economic growth and a high volume of financial activities around the world. The extra liquidity boosted the economy and asset prices. The government's intent for the 'new money' was to lend to companies in order to drive increased business activities, particularly capital intensive investments. Unfortunately, a significant portion of the loans went to the best customers such as investment banks and hedge funds instead. They used this easy money to fund financial trades to inflate all asset prices, from stocks to bonds, commodities to real estate. Easy money also encouraged borrowing for all, from governments to corporations to individuals in terms of bonds and loans - the net effect is an enormous increase in total debt and leverage around the world. Ill effects of easy money misdirect much of the debt to create excess production capacity, encourage risky financial activities such as currency and carry trades, and bail out of zombie governments. Much of this poorly conceived debt is in trouble and facing potential default, when either the debt or interest rate becomes too high as world economy growth slows. These losses, which will be realized eventually by some entity, undermine future financial stability of the banks and governments. An interesting fact about debt - it will not go away until restructured or merged to a new receiver. Bond holders of these poor quality debts will suffer losses. The aggregate debt load and discounts arising from defaults will inevitably create the next crisis. The first crack appears when the interest rate of the lower quality debt (junk bonds) increases when QE slows, because either the central bank balance sheet becomes too high or congress sets the limit. For example, US High Yield (junk) bonds have declined since July 2014 for a period of 18 months accumulating a 20% loss and entering into bear territory. The Fed can consider steps to stabilize the markets by starting and expanding the purchase of US High Yield bonds through ETFs. This would be a sensible and effective move to support US companies.

Figure 5

Globally, from the initial and necessary QE to the continual expansion of QE to date, the new liquidity and thirst for economic growth has promoted excess optimism. The rosy growth projection resulted in surplus global production capacities. When world consumption slows, prices descend and commodities are hit hard. All the borrowings by companies from many industries to increase excess capacity are suffering from the debt burden, declining sales and the stock prices. This is the transition from the virtuous to the defective cycle of QE.

The potential 'debt crisis' can cause world stock markets to fall one by one. Foreign currencies, stocks and bonds impacted by these trends are already in bear market territory. Currently, stock markets in Germany, United Kingdom, Canada and China have fallen by more than 20%. The distressing but inevitable sequence unfolds as junk bond interest rates rise forcing defaults. Confidence wanes as stock markets start to slide. Further QE has lost its effectiveness as government bond interest rates begin to increase, liquidity becomes acute leading to even more defaults on weaker junk and foreign government bonds. Some foreign banks are experiencing losses on these debts. The strong US dollar makes repayment in US denominated debt outside US even more difficult. All these events have happened or are in the process of being realized. Each stock market will react to the financial turmoil accordingly with respect to debt loads and future government stimuli. However, these actions may amount to short reprieves but not a fundamental fix.

Click to enlarge

Figure 6

Table 1

Markets

Germany

UK

Japan

China

US

Canada

ETF

EWG

EWU

EWJ

MCHI

SPY

EWC

High Week

6/2/2014

6/16/2014

8/25/2014

4/20/2015

5/18/2015

8/25/2014

% Decline 01/25/2016

-25%

-32%

-15%

-40%

-11%

-37%

Click to enlarge

The table above shows the weekly declines of world markets from the highs experienced by each country-level ETF with the starting point of January 1, 2014.

Standing out from rest of the world, US have been the last to feel the contagion since the S&P 500 peaked only 8 months ago. Starting 2 months ago, the index has experienced a substantial and accelerated fall initiated by a weakening of economic indicators confirming slower growth than previous years. Whether the current market correction will slide further is anyone's guess. Future world events, government policies and performance of the US economy will dictate the direction of the market.

Tracking the last 2 bear markets in 2000 and 2008, we postulate about the 2016 possibilities. Judging from the bear market price trends from previous elections, the immediate future appears to be rocky and challenging as we approach the Presidential Election only 9 months away.

Conclusion

Observing the trends and events around the world, the US stock market appears to be vulnerable and heading towards bear market before the election.

  1. The increasing total debt will become more problematic when reduced liquidity leads to the rise in high yield interest rates and more debt defaults that shake investor's confidence.
  2. Reduced economic growth outlook lowers future earnings. P/E ratio can also drop from the current above average level.
  3. Poor stock market performance around the world may pull US market down.
  4. Election anxieties and political uncertainties similar to the past 2 elections may force investors to the sideline.

Therefore, for the next 9 months, investors need to be more conservative, build up cash and be prepared for buying opportunities. Another investing approach is to shorten trading cycles to realize profits. Buying gold makes sense now in the negative interest rate environment for Japanese and European markets, for us too. By observing and adapting to the market movement, we can protect our assets and may even profit from the volatile environment ahead. Barring another QE from the Fed or other central banks, the rest of 2016 will likely be tough for US stock market.

Paul Wong 01/29/2016

(For discussion purpose only, not intended for any investment advice)

Disclosure: I am/we are long SPY, GLD, EWJ, MCHI.

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.