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Stocks Bear Market Looms

Stock-Markets / Stocks Bear Market Aug 23, 2013 - 07:03 PM GMT

By: Zeal_LLC

Stock-Markets

The US stock markets have enjoyed a dazzling year, levitating to a long series of new record highs.  But this relentless advance has stalled in August, with selling pressure mounting.  Even most of the bulls readily agree that a material selloff is overdue after such a mighty run.  But actually the odds are high this necessary retreat will extend well beyond normal pullbacks or even corrections into a new cyclical bear.


The mere idea of a looming stock bear is certainly heretical these days, but this is not surprising.  By early August, the flagship S&P 500 stock index (SPX) had powered an astounding 152.7% higher since March 2009!  Being so deep into such a spectacular cyclical bull has naturally left speculators and investors very complacent.  Most have forgotten that markets don’t move in one direction forever, they flow and ebb.

Still, late in mature cyclical bulls the ever-rising chances for the birth of a new cyclical bear are the last thing traders want to hear.  So let’s shelve that controversial thesis for now and start at common ground.  Nearly every smart bull either expects a material stock-market selloff or thinks one would be very healthy.  And technical and sentimental indicators are nearly unanimous in declaring the SPX very overbought.

Discussing all of these would require a sizable tome, but here’s an overview.  The SPX is stretched far above its trailing 200-day moving average.  Complacency is extremely high and fear non-existent as measured by key sentiment gauges.  2013’s SPX levitation has been on low and dwindling volume and narrowing market breadth, with fewer and fewer individual stocks maintaining the rally’s momentum.

Students of the markets can elaborate on these major topping indicators in depth, and expound on dozens more.  So the bears and smart bulls alike definitely agree that some kind of material selloff in the US stock markets is either already underway or imminent.  The only real questions are about its ultimate magnitude and duration.  The difference between a down day and a bear market is simply one of degree.

This is reflected in how material stock-market selloffs are categorized.  Anything under 4% is merely a series of down days without any formal name.  When selloffs extend from 4% to 10% off their preceding highs, they are called pullbacks.  Once they forge over 10%, they become known as corrections.  And if the selling continues long enough to push them over 20%, these selloffs become cyclical bear markets.

Pullbacks are fairly common in cyclical bull markets, usually on the order of 3 or 4 per year.  Corrections are considerably rarer, only happening about once a year on average.  Both types of selloffs are critical for keeping bull markets healthy.  They act to rebalance sentiment, bleeding off greed before it grows excessive enough to threaten the bull market’s very existence.  Selloffs are an essential safety valve.

One of the primary reasons a material selloff is so overdue today is the remarkable lack of them since mid-November 2012 when this year’s relentless levitation was born.  During the 9 months since, there has only been one pullback and zero corrections.  As this first chart shows, this is very anomalous.  The longer a bull market goes without a material selloff to rebalance sentiment, the more precarious it gets.

Even by the precedent of today’s cyclical bull, the recent lack of material selloffs is striking.  The SPX is rendered in blue below, with every pullback and correction of its entire bull run noted in yellow and red respectively.  Especially the past year or so is really conspicuous for the absence of these healthy and essential events.  The benchmark VIX fear gauge is also shown in red, warning of extreme complacency.

In the 8.5 months between mid-November 2012 and early August 2013 where the SPX soared 26.3% higher, there’s only been one material selloff.  And at 5.8%, it was merely a smallish pullback running between late May and late June.  There were minor series of down days amounting to 3.1% in late December, 2.8% in late February, and 3.2% in mid-April, but they didn’t even approach pullback magnitude.

As of the middle of this week, August’s nascent SPX selloff had grown to 3.9%.  But all these selling events were very minor.  The smaller the selloff, the less greed it bleeds off and thus the more sentiment remains out of balance.  Prior to 2013, the average pullback in the SPX’s entire mighty cyclical bull was over 7.0%.  So the lone 5.8% in the past 9 months’ incredible levitation is far from sufficient to rebalance.

And that explains the rampant euphoria plaguing the stock markets this year.  The financial media has been bursting at the seams with analysts and traders touting stocks as the only place to be.  Many have been arguing a correction-magnitude selloff is all but impossible!  Talk about hubris.  The longer any bull market goes without big-enough selloffs to deflate greed, the more this dangerous emotion flourishes.

Thus long stock-market levitations without material selloffs inevitably lead to full-blown corrections.  The last example occurred back in mid-2011, when the SPX corrected sharply.  Much like today, it had spent 9.9 months levitating with only two mild pullbacks.  So when the selling finally arrived, it was big.  So much complacency and greed had built up that it took a serious 19.4% selloff to fully eradicate that imbalance.

The parallels between that last SPX levitation and today’s are ominous.  Measured by that flagship index, the stock markets had climbed 33.3% in 9.9 months.  Today we are at 26.3% in 8.5 months.  The second pullback of that earlier levitation occurred late in it, and was relatively mild.  A slightly-higher secondary top was seen soon after as the perma-bulls foolishly refused to heed the dangers of overbought markets.

Sound familiar?  The technical pattern we’ve seen in recent months matches the early-2011 topping pattern remarkably well.  A long SPX levitation sans-pullbacks generated extraordinary complacency and greed, and the initial mild pullback was ignored by the bulls.  Their topping-indicators-be-damned buy-the-dips mentality was able to bully the SPX up to a secondary high on low volume, but it soon failed too.

And thus a correction arrived then and is certainly overdue now.  On average a correction-magnitude selloff happens about once a year in a healthy cyclical bull market.  As of early August’s recent high, the SPX had gone a breathtaking 22.0 months without a correction!  That just boggles the mind.  This bull’s previous spans between corrections were merely 13.5m and 9.9m.  Never has one been more overdue.

Corrections are easy to comprehend in the abstract, but are scary events to weather.  They force stock prices down so close to bear-market territory that most of the greedy traders who were hyper-bullish at the preceding top totally capitulate.  Back in both mid-2010 and late 2011 just after this cyclical bull’s previous corrections, I wrote hardcore contrarian essays that were very bullish when everyone else was terrified.

Corrections drag the great sentiment pendulum from extreme greed and complacency at the preceding top to extreme fear and despair at that selloff’s nadir.  A merely average correction is 15%.  Measured off the SPX’s latest early-August peak, that would hammer the SPX back down to 1453.  That’s not only 11.5% lower than this week’s levels, but would erase the SPX’s gains for this entire calendar year!

But it’s been so darned long since this cyclical bull has seen a necessary and healthy correction that I can’t imagine it will be small or average.  Complacency is always high at major toppings, as measured by the low VIX.  Since this implied-volatility index effectively measures prevailing fear, a low reading shows the absence of it which is complacency.  Recent months’ VIX lows have revealed extraordinary complacency.

So even if this cyclical bull is alive and well and has years left to run as Wall Street analysts have boldly asserted all year long, a big correction is overdue and inevitable.  The last correction was 19.4% in mid-2011, which is about as big as they can get.  A similar event today off the recent highs would crush the SPX down to 1378, another 16.1% below this week’s levels.  Just imagine the havoc that would wreak!

Round that big-correction target to 1375.  This mighty cyclical bull first challenged 1375 in April 2011, and first achieved it a year later in March 2012.  So at the nadir of the next correction, somewhere between 1.4 and 2.3 years of this entire 4.4-year-long cyclical bull’s gains will have vanished!  Both investors and speculators alike will have had their wills broken by that point, being extremely pessimistic and bearish.

Remember that the difference between a down day and a cyclical bear market is merely one of degree.  There is simply no arguing that the US stock markets are way overdue for a major correction.  And once that comes to pass, and the SPX is 17%, 18%, 19% off its recent peak, it won’t take much additional selling to push it over that 20% threshold.  One big down day would do it.  That would make a new bear.

Now calling for a new cyclical bear market in stocks is not something that can be done lightly.  Material selloffs that ultimately grow big enough to exceed 20% only happen in very specific conditions.  I didn’t even start thinking about one until a year ago.  Back in mid-2011 halfway through the last major correction, I even actively argued against a new cyclical bear.  Cyclical bears are only born when cyclical bulls mature.

The really ominous thing today is our current cyclical bull is long past mature.  It has lasted much longer and risen much farther than average, which is the real reason a new stock bear looms.  While Wall Street and the vast majority of investors are loath to admit it, we remain mired deep within a secular bear.  These are simply very long consolidations, where the stock markets grind sideways for a whopping 17 years.

Stock markets move in great third-of-a-century cycles I call Long Valuation Waves.  The first half of each single wave is a secular stock bull, and the second half a secular stock bear.  The entire reason the bear half exists for those 17 long years is to allow stock-market valuations to mean revert from excessive highs at the ends of the preceding bull.  Like all major market reversions, they overshoot before the bear ends.

These secular bears force stock markets to grind sideways on balance, giving underlying corporate earnings time to catch up with high stock prices.  Mechanically this happens through a series of shorter cyclical bears and cyclical bulls within the secular-bear span.  It is nearly impossible to be a successful investor if you don’t understand these secular and cyclical cycles and their impact on stock prices.

This next chart shows our current SPX secular bear superimposed over the last one between 1966 and 1982.  This perspective is invaluable yet hard to find, the financial media almost never talks about it.  Wall Street perpetually tries to convince investors that anytime is a great time to buy stocks.  But the investors who foolishly buy general stocks high near the ends of mid-secular-bear cyclical bulls get slaughtered.

The past 13 years’ secular bear dominates the long-term SPX charts, it is undeniable.  Stocks have simply ground sideways at best since the last secular bull topped in March 2000.  While the financial media has been elatedly celebrating new record highs this year, at best the SPX was only up 11.9% over the 13.4 years between March 2000 and August 2013.  This compounds to about a 0.85% annual return.

Earning capital gains in the general stock markets of less than 1% per year at best for over 13 years is horrendously bad.  Factor in inflation, and there were actually big real losses.  Dividends helped offset some of these, but overall the long-term investors who stayed invested throughout this secular bear have still suffered substantial losses at best.  Secular bear markets are brutally unforgiving, eviscerating the naive.

Their sideways grinds are a series of cyclical bears and bulls.  The cyclical bears generally cut stock prices in half, and then the subsequent cyclical bulls generally double them again back up to their starting point.  So while secular bears slaughter buy-and-hold investors, they are very profitable to trade.  The key is buying stocks when they near secular support, then selling later when they hit secular resistance.

Secular support and secular resistance on the SPX are around 750 and 1500 respectively.  Support is hit after mid-secular-bear cyclical bears, and resistance is hit after mid-secular-bear cyclical bulls.  Like any technical lines, these are zones and not hard limits.  The SPX can overshoot in both directions, but not for long.  Soon the dominating secular trading range reasserts itself and sucks the SPX back into its maw.

In late January 2013, the SPX broke above this 1500 secular resistance.  In late March, it edged up to new all-time nominal highs (though it had and still remains far from real ones).  The last mighty cyclical bull topping in October 2007 overshot as well, but soon succumbed to the unyielding secular bear.  So not even 1700 on the SPX gets us out of the woods until the bear’s mission has been accomplished.

And that is to force the stock markets to trade sideways for long enough for valuations to plunge from extremely overvalued to extremely undervalued levels.  In P/E-ratio terms, secular bears are born at general-market valuations above 28x earnings (twice the 14x long-term fair value) and end around 7x earnings (half fair value).  Today’s secular bear won’t end until the SPX hits 7x earnings once again.

When it was born way back in early 2000, the SPX traded in a spectacular bubble at 43.8x.  7.6 years later in October 2007 when the last cyclical bull topped, its P/E ratio had fallen to 21.3x.  While the SPX was at the same levels, corporate earnings had grown enough to cut valuations in half.  But stocks were still very expensive.  Even during those epic stock-panic lows in early 2009, the SPX only fell to 11.6x at worst.

That was 9.0 years into this secular bear, and the best chance the stock markets had to hit those 7x secular-bear-ending levels.  They failed, virtually assuring this valuation-driven secular bear would continue for its entire 17-year normal duration.  Today 13.4 years into that span, the SPX is once again at the same high topping valuation of 21.2x seen in late 2007.  Its work far from done, this secular bear is far from over.

Greatly amplifying the danger today, the SPX is not only far above its secular-bear resistance of 1500 but the current cyclical bull has powered far too high for far too long.  It is up an astounding 152.7% over 4.4 years (or 53 months)!  Meanwhile the average size and duration of modern mid-secular-bear cyclical bulls is only a doubling over 35 months.  The more excessive the extreme, the bigger and faster the mean reversion.

The secular bear that has been plaguing the stock markets since early 2000 hasn’t even come close yet to accomplishing its mission.  Today’s stock-market valuations are three times higher than the 7x target, and even at their lowest point in early 2009 were still 2/3rds higher.  And this secular bear still remains several years away from hitting their tight average duration of 17 years.  It hasn’t had sufficient time to mature yet.

So as you can see, the US stock markets are in an extraordinarily dangerous place today.  They are very overdue for a selloff, and that almost certainly has to grow into a major correction to rebalance sentiment.  And one or two sizable down days late in a major correction when sentiment is dismal is all it takes to push the SPX over that 20% threshold into cyclical-bear territory.  These ultimately cut stock prices in half!

With today’s stock markets euphoric and overbought, with the recent years’ cyclical bull way too old and too high, investors and speculators alike have to be exceedingly careful in the months to come.  Wall Street will deny the coming selloff is meaningful every step of the way down, lulling traders into false security until it is way too late.  You need proven battle-hardened contrarians to help you navigate this transition.

That’s us at Zeal.  We’ve spent decades intensely studying and trading the markets.  We buy low when others are afraid and then later sell high when others are brave.  Fighting the crowd has proven wildly successful.  As of the end of June, we’ve recommended and realized 655 stock trades to our newsletter subscribers since 2001.  They averaged stellar annualized realized gains of +28.6% during a secular bear!

We publish acclaimed weekly and monthly newsletters for speculators and investors.  In them I draw on our decades of hard-won experience, knowledge, wisdom, and ongoing research to explain what is going on in the markets, why, and how to trade them with specific stocks as opportunities arise.  Alternative investments including gold thrive in cyclical bears.  So if you’ve not been paying attention to the markets, now is the time to get focused again.  Big changes are afoot.  Subscribe today!

The bottom line is the US stock markets are overdue for a material selloff after their massive levitation this year.  And this has to snowball into a full-blown correction since it has been so anomalously long since the last one.  Today’s euphoric sentiment will be so ravaged by the time that correction hits the high teens that it won’t be hard for it to edge over 20% into cyclical-bear territory.  That will push the selloff target to 50%ish!

A new stock bear looming is far from a radical idea, it is merely a high-probability mean reversion.  The ongoing secular bear remains too young to give up its ghost, and far from accomplishing it valuation mission.  Valuations remain very expensive, while the SPX’s cyclical bull is extremely overextended in both magnitude and duration terms.  In light of all this, it’s hard to imagine a new stock bear not being born.

Adam Hamilton, CPA

So how can you profit from this information? We publish an acclaimed monthly newsletter, Zeal Intelligence , that details exactly what we are doing in terms of actual stock and options trading based on all the lessons we have learned in our market research. Please consider joining us each month for tactical trading details and more in our premium Zeal Intelligence service at … www.zealllc.com/subscribe.htm

Questions for Adam? I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/adam.htm for more information.

Thoughts, comments, or flames? Fire away at zelotes@zealllc.com . Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

Copyright 2000 - 2013 Zeal Research ( www.ZealLLC.com )

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