"Markets can stay irrational longer than you can stay solvent."
I recently wrote an article on how the next market crash will happen. One fact that I failed to emphasize in that article is that market crashes come in two flavors, which I'll call Type I and Type II. In brief, a Type I market crash is the standard lead-in to a bear market as part of a normal business cycle.
A Type II market crash is a rare once-in-a-century market crash characterized by the corporate abandonment of profit seeking in favor of balance sheet repair. This is the market crash flavor I discussed in the last article. It is also the type of market crash no one is attempting to predict.
While I believe a Type II market crash is soon on the US's horizon and that a Type I market crash could possibly be the catalyst for a Type II market crash, after much research, I do not believe a Type I market crash is coming. In fact, I believe we already missed it. We are likely heading toward a new bull market.
Type I Market Crash
A Type I market crash can come in various speeds, the longer of which are typically referred to as bear markets. Bear markets are healthy for the overall market cycle because they create washouts. In a washout, fear and pessimism are allowed to be expressed to bring the market to a relative bottom, at which stock prices are more fairly valued.
Once fear and pessimism peak, the washout ends. Other investors step in and buy stocks, which are seen to be undervalued. The fearful and pessimistic traders are gone from the market, and their respective indicators decline.
Currently, fear seems to be at a relative high. Well-known investors, such as George Soros, are publicly stating their bearish sentiment. The VIX, commonly referred to as a fear gauge for the market, is also at a relative peak:
The Fear Is Unwarranted
I see this as unwarranted. The VIX will again turn downward as fear surrenders to logic. The current bearish sentiment - based on assumptions of a Type I market crash - is unwarranted.
Many of the economic indicators that are being targeted as evidence for a weakening economy do not support a Type I market crash. For instance, take GDP growth, which has been weakening. Some point to the official GDP growth statistics being reported with bias and calculated without including inflation adjustments, but even if you account for these aspects in GDP growth, GDP still does not a support evidence for a Type I market crash:
Note that the alternative GDP growth statistic has been negative since 2004, a period covering two bull markets and a bear market. Weak GDP growth does not correspond to a market crash. Only significant decreases in GDP growth correspond to crashes.
But Stocks Are Overvalued!
Another argument is that stocks are overvalued. This is hard to argue with, as price-to-earnings ratios seem to be extremely high. However, anyone who remembers the last decade will have seen this level of P/E ratios before:
It is not huge P/E ratios that are the problem. Instead, it is sudden spikes in P/E caused by buying frenzies in speculative areas. The rise of the S&P 500's P/E ratio from 2000 to now has been rather moderate.
We can still find stocks trading at low P/E and price-to-book levels. In fact, these undervalued stocks typically outperform the market in the long run. Value still can be found in this market.
Is a Market Crash Coming?
Instead of being dragged down by bad news, investor sentiment, and economic indicators taken out of context, we should be asking ourselves: Is a Type I market crash warranted now? The answer to that question is the same as the answer to whether the current market participants are fearful enough to create a washout. My brief and blunt answer to this is "no."
This bull market has been cited as the second-longest in the US stock market's history. Naturally, a bear market is around the corner, right? Not if it already occurred - below we see the SPDR S&P 500 ETF (NYSEARCA:SPY):
The phenomenon of a Type I market crash in a healthy economy is to wipe out fear from the market. From May 2015 to Feb 2016, we witnessed two washout periods in which fearful investors sold their stocks. Washout 1 drove out the most fearful investors, evident by the almost vertical drop in price and huge spike in volume. Washout 2 gave investors a second chance to ditch their stocks - the downward trend was slightly lighter and on a more even spread of volume.
Washouts Set a New Bottom
During the second washout, stocks hit a lower bottom, at which prices were deemed to be too low. With less fear in the market, investors began buying to bring stocks back to more reasonable levels. The peak in May 2015 was followed by stock prices that were declining - on average - for the next nine months:
Those nine months included two sporadic panic selloffs with a greedy buying phase in between. But overall, it can be seen as a bear market followed by a new bull market instead of the common explanation of "two market corrections" within a bull market. The common explanation is hard to justify, as it assumes the past 13 months, in which no upward progress has been made, can be considered a bull market.
The shortest official bear market was six months, from Jan 1980 to July 1980. But we have also seen eight other bear markets that lasted fewer than 12 months. Why are we still calling the last 13 months an extension of a market that already peaked?
We Missed the Bear Market
Applying the patterns below, we see that the May 2015 to Feb 2016 period certainly meets the criteria for a bear market:
The May to Feb market dropped by 15% in 9 months. Although the drop was sporadic, it fits with the time and %change patterns in the above chart. But more importantly, the bear market performed its duty in driving out fearful investors; talk of a bear market has been declining since March:
I believe that the two drawdowns have done their job in driving out the pessimists. If so, investors should be willing to take on new levels of risk, pushing the market to higher levels. The earlier we recognize that we just passed a bear market and not a retreat within a bull market (if we defined it this way, it would be one of the longest retreats in bull market history), the earlier we can join investors in purchasing at what can be seen as the entry point to a new bull market.
What's the Point?
The point is simple: the best time to invest is when pessimism resets the market. From here, our upside should not be seen as limited, as the investors entering the market are more likely to be risk-seeking, not risk-averse (those investors tend to enter after strong momentum has already built, missing much of the profits). The risk-averse have already sold-off on the fear of a recession that is unlikely to come.
We should see this as a buying opportunity. Investors selling on fear typically stay out of the market for an extended period. But eventually they return to the market, as momentum returns, further driving up stock prices.
The next Type I market crash is likely far away. The two drawdowns effectively acted as a bear market in two large bursts, resetting the bull-bear cycle. Enough public investors were driven out of the market to lock in a relative bottom.
Until a Type II crash comes, the market will always go up in the long term. The recent bear market has merely reset the bull part of the cycle. At this moment, I see more upside than down.
Learn More about Earnings
My Exploiting Earnings premium subscription is now live, here on Seeking Alpha. In this newsletter, we employ both fundamental and pattern analyses to predict price movements of specific companies after specific earnings. I offer specific strategies for playing those earnings reports. To-date, we are 90% accurate on earnings report predictions.
Disclosure: I am/we are long SPY.
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.