This Is How A Bear Market Starts

Summary

• At this advanced stage of the six year bull market, some investors are understandably concerned about how much higher stocks can go from here.
• How can investors know when the bull market in U.S. stocks has finally ended and a new bear market has gotten underway?
• Fortunately, today’s stock market is providing a live and active case study right now that is demonstrating exactly what it looks like when a bear market is just getting started.

We are now in the sixth year of what is the third longest U.S. stock bull market in history. At this advanced bull market stage, some investors are understandably concerned about how much higher stocks can go from here. This leads to the following natural question - how will I know when the bull market has finally ended and a new bear market has gotten underway? Fortunately for those that are interested, today's stock market is providing a live and active case study right now that is demonstrating exactly what it looks like when a bear market is just getting started.

The Energy Sector Ablaze

For those that want to know what the beginning of a full blown bear market looks like, the energy sector (XLE) is the place to look.

Oil and gas stocks as measured by the Energy Sector Select Sector SPDR peaked in late June at a dividend adjusted $101.00 per share. But since this summertime peak, the XLE has fallen precipitously. It was down as much as -23.2% from its peak during the correction in September and October. In the process, it cut through all of its major support levels like a hot knife through butter.

By mid October, the XLE bottomed along with the rest of the market and began to rally. But it soon failed at what had since become resistance at its 400-day moving average and shifted violently to the downside once the news was released that OPEC was not cutting back on production coming out of their late November meeting. Since that time, the XLE dropped as much as -28.2% below its June highs, breaking through its October lows in the process. This pricing sequence, of course, is known as "lower highs and lower lows", which is certainly bearish from a technical perspective. And despite what has been a phenomenal +6.30% bounce on Tuesday and Wednesday of this week from recent lows, it has only brought the index back to what is now resistance at the previous lows in October. Perhaps the XLE will continue to advance to the upside in the coming trading days, but a great deal of damage has already been done.

This Is An Energy Problem . . . For Now

So how can we even begin to consider that a sustained bear market is underway in energy stocks? After all, haven't we seen the market pullback time and time again since the financial crisis calmed down in early 2009 only to see it eventually catapult to new highs? Yes, stocks have been remarkably resilient to this point, and it should be noted that the bull market for the other eight major sectors of the U.S. stock market - materials (XLB), industrials (XLI), consumer discretionary (XLY), consumer staples (XLP), health care (XLV), financials (XLF), technology (XLK) and utilities (XLU) - remains very much intact.

But the price behavior for the energy sector is decidedly different. The charts are now broken. And from a fundamental perspective, it is easy to see why. Yes, global demand for oil remains steady if not continuing to gradually rise despite signs of economic weakness across many parts of the world. But rapidly accelerating global oil production, specifically out of the United States, has resulted in supply that is meaningfully and increasingly in excess of demand. And given that OPEC in general and Saudi Arabia in particular have no intent on curtailing their own production any time soon, the imbalance between supply and demand is likely to get worse before it gets better. Thus, oil prices have fallen. And those paper speculators that were aggressively long oil with leverage throughout 2014 are being increasingly forced out of positions with liquidations that are only serving to push the oil price even lower.

Will oil prices stabilize? Eventually. Perhaps they already have as of Tuesday. Then again, maybe more liquidation activity is yet to come that will force the price even lower. But the more important question is exactly where will the price stabilize? And what leveraged oil producers will be able to survive and which will die at this new price level? Unfolding prices in high yield credit markets suggest that a number of companies are already on the ropes. And the likelihood of further liquidation and prospective defaults within a sector are typically not the recipe for a major sustainable price bounce in the days, weeks or months ahead.

In fact, it is highly unusual for one sector of the market to meaningfully struggle while all others continue to thrive. For eventually, other sectors take notice and often find themselves pulled lower. But we are not at this stage of the process just yet. After all, the bear market in energy is just beginning, if it sustains itself to the downside at all. Whether it does or not remains to be seen, but the one thing that is for certain following Wednesday's FOMC meeting is that the Fed is not riding to the rescue with liquidity this time around. Energy stocks are now on their own and markets will be left to decide how things play out from here.

An All Too Familiar Pattern Now Developing

We have seen this story before. History does not repeat itself, but it often rhymes, and the energy sector has many of the characteristics that have defined so many bear markets in the past.

Let's begin with an overlay of the Energy SPDR against the 2000 to 2002 bear market in U.S. stocks as measured by the S&P 500 Index (SPY). The pricing pattern is strikingly similar through the first 125 trading days between these two positions. And what we see from the S&P 500 highlights and important point. It would not be surprising at all to see oil stocks rally meaningfully for an extended period of time, perhaps even a couple of months. But investors should be cautious if such a rally were to take place. For it is during such rallies that still bullish investors increasingly entangle themselves in the bear trap from which they eventually cannot escape. A key to watch if such a rally in energy stocks were to take place is whether they can decisively break the downtrend and resume the pattern of setting higher highs and higher lows. If not, any such rally could prove to be a head fake.

Now let us examine an overlay of today's energy sector with that of the S&P 500 Index during the financial crisis from 2007 to 2009. What is immediately notable is that after tracking the pattern of this bear market for the first 110 trading days, the energy sector has deviated sharply to the downside. Yes, the price behavior from energy stocks through the first 125 days of its correction is notably worse than that of the financial crisis several years ago. This highlights another important point about today's bear markets. Given the massive amounts of leverage that continue to fester in global capital markets, the potential for massive liquidation sell offs and sharp and unpredictable cascades to the downside loom as large as ever in today's markets. Do the magnitude of these sell offs make fundamental sense? Usually no, but when a bunch of major players that are highly leveraged in a particular position are forced to sell, not much can make sense for an extended period of time before things finally start to settle out.

The third and final comparison is versus gold (GLD). Once again, the similarities in price behavior are striking. But some have recently suggested that the comparison between oil and gold is not relevant because oil has a productive economic purpose in the global economy whereas gold does not. My response to this point whether it is true or not is that it does not matter. Whether you are focused on stocks or bonds or industrial commodities or precious metals or anything else, sentiment plays just as important part if not more so than underlying fundamentals when it comes to price performance. And if a stock or a sector or an asset class falls out of favor with capital markets, it can either fall or languish far longer than most rational investors might reasonably expect. Thus, those positioning today for the eventual strong bounce back in oil and its related energy stocks sometime in the next year or two may find themselves repeatedly frustrated and eventually flushed out even if their underlying fundamental thesis turns out to be right along the way.

These are just a few of the many examples of past bear markets that look similar to what we are seeing develop in the energy sector today. Perhaps it will play out differently for oil and the energy sector this time around, but at a minimum great caution is warranted at this stage.

The Persistent Confidence Of Energy Investors

It is on this final point where investors find themselves trapped in a bear market. Undoubtedly, the damage has been severe in the oil market and the energy sector since the summer. And as shown above, we are seeing a troubling bear market pattern only beginning to form in the energy space. Yet it is striking how many investors remain supremely confident in the energy positions that had up until a few months ago been working so well for their portfolios. For many, this is an epic buying opportunity ahead of an inevitable bounce back to $100 oil right around the corner. And they express this bold view not only with confidence but also with a degree of swagger and bite against those that expect otherwise. Perhaps such a meaningful bounce will soon come to pass, and I hope for the sake of these investors that it does. But I remember scores of stock investors during the 2000 to 2002 and 2007 to 2009 bear markets making the same arguments only to eventually collapse under the weight of the market correction. And I remember scores of gold investors - I was included among them - that made these same well-founded arguments for years during the three-year bear market that remains ongoing in gold to this day.

Thus, it is important for those that are actively invested in the energy space at this stage of the market correction to openly consider opposing views instead of railing against them. One's bullish stance may ultimately be proven right, but in the event that it is not, taking the time to meaningfully consider other points of view will not only go a long way in protecting against downside risk but may also help avoid getting so caught in an unfolding bear market that it finally becomes impossible to get out without irreversible capital losses.

These remain trying times for those that are invested in the energy space. And if history is any guide, conditions could get meaningfully worse before they get better. But by knowing how these bear market episodes unfold and how to react accordingly, one can go a long way in protecting the principal value of their investments.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Disclosure: The author is long XLU. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.