The last few weeks have been very eventful for equity investors. In just one week, all the gains since 2014 have been wiped out. The question is: "Is this a buying opportunity or is this the start of a bear market?" I'll make the case that we are going much lower, if the Federal Reserve doesn't act in its September 16-17 meeting.
First and foremost, let's look at the valuations (Gurufocus.com). Even though we had a 10% crash in the Dow Jones (NYSEARCA:DIA), the market is still significantly overvalued (117.5%) compared to GDP.
We expect that Q3 2015 GDP growth will be at most 2.8% and could be as low as 1.3% (see chart below from cnafinance.com). That's a large drop from Q2 2015 GDP, which is at 3.7%. We would have to drop more than 30% to get a fairly valued stock market.
Second, we don't expect that GDP will be rebounding anytime soon as the business inventory to sales ratio is hitting new highs (See chart below from FRED). Inventories can be considered a part of a group of leading indicators of business cycles. Whenever inventories surge, a possible reason could be a decrease in consumer demand. The result is that producers will cut output and sales. This will translate in a lower GDP growth. The chart below shows that the inverted business inventory to sales ratio is declining, pulling GDP growth with it.
We also see confirmation of a slowdown in GDP growth in the ISM Purchasing Manager Index, which fell to a low of 51.1 in August.
Third, one of the most reliable leading indicators is flashing code red. The junk bond market (high yield corporate bonds) is plunging (see chart below from FRED). Since mid 2014, high yield bonds have been dropping and we are only seeing the consequences in the stock market today. The yield spread between high yield corporate bonds and the 10 year U.S. treasuries is rising and this means that the stock market bubble is popping.
Fourth, when we look at the Dow Theory, the Dow transportation average (leading index) has been plunging as compared to the Dow Jones (see chart below from FRED). When both indices don't confirm each other's movement, it is clear that the Dow Jones will be following the leading Dow transportation average lower.
All of these points we discussed above are recessionary indicators. I believe we are on the verge of a bear market in stocks and the only savior is the Federal Reserve. However, they have just run out of bullets.
First off, interest rates are at 0%. If we enter a recession, there is no other way for the Federal Reserve than to apply negative interest rate policies. This event would put pressure on the U.S. dollar (NYSEARCA:UUP). They couldn't increase interest rates because of the following conundrum. The Fed funds rate is currently set at 0.25%. They have 2.6 trillion of excess reserves on the Fed balance sheet at this rate (see chart below from FRED), which all was created due to zero interest rate policies started in 2008. If the Federal Reserve were to increase rates, they would attract more money from the banks into the Fed balance sheet. That would worsen the lending environment in the economy, it would be the opposite of what the Federal Reserve wants, namely sending money from the Fed balance sheet into the economy.
Another reason why the Federal Reserve is reluctant to increase interest rates is the low inflation number. When we take the chart of the consumer price index (see chart below from FRED), we can easily see that inflation dropped to 0% year over year growth. There is no way the Federal Reserve will increase interest rates with these numbers.
The unemployment rate isn't improving either. When we look at how many people have dropped out of the labor force (labor force participation rate of 62.8%), there is little incentive to increase rates (see chart below from FRED).
Finally, we know just recently that the Chinese are selling their foreign U.S. reserves (U.S. treasuries) via Belgium and Switzerland. So we are not even safe in U.S. treasuries. If the Federal Reserve were to increase the Fed funds rate, this would put even more pressure on U.S. treasuries.
So an interest rate hike is pretty much off the table. Instead, I believe we will see more quantitative easing. Especially when we are this close to another debt ceiling debacle. It is expected that the Treasury Department is about to run out of money mid-November. They would have to raise the debt ceiling at that time. Each time when we saw a debt ceiling problem in 2011 and 2013, the stock market had a dip down because QE was exhausted (see chart below). Now in September 2015, due to tapering, QE is exhausted once again while a new debt ceiling crisis is emerging. The only way to resolve this is QE4. This would sink the U.S. dollar and ignite a surge in precious metals (NYSEARCA:GLD).
I advise investors to act accordingly and to make trades away from the U.S. dollar (due to QE4), stocks (due to high valuations and plunging high yield credit), bonds (NYSEARCA:TLT) (due to selling from China and a lower U.S. dollar) and into precious metals.
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.