I’m going to try and make this simple for non-professional investors, and perhaps for some professionals as well.
A leg up in a bull trend has obviously ended at S&P 500 2941,and so now the debate is whether the stock market has begun just a correction in an ongoing bull trend, or if a bear market is now in its early phases. A bear market has no official definition, but the generally accepted guideline is corrections are less than a twenty percent decline, and bear markets decline twenty percent, or more, off the high. Lay people may want to think of this as the difference between a nasty cold, and a potentially deadly case of pneumonia.
Bear markets have been promoted by big institutions as lasting about 18-24 months, so they say investors should just ride out the pain and not try to avoid it, since of course that is impossible (especially for them). In addition to being obviously self-serving, these ruminations are grossly inaccurate, and most likely a product of data mining. For example, there was a bear market lasting from 1966 to August 1982, sixteen long years, with the Dow locked in rallies and declines from 500 to 999. Finally in August 1982 the Dow rocketed higher supported by huge positive numbers in numerous measures of market strength. And, oh yes, there have been bear markets lasting decades, a biblical lifetime type bear in England comes to mind, and a multi-decade bear in Japan, which began in 1989. So the bottom line in this brief bit of history is bear markets must be respected as the ultimate destroyer of investment wealth.
Given that the difference between corrections and bear markets is a matter of not only of time, but also in terms of wealth destruction, then investors should do all they can to avoid becoming participants in the latter.So where are we now in this exercise of probabilities, which may have profound implications for growing, or protecting, the wealth of investors? Here is the most simple and straight forward answer I can offer given the current status of an array of supply and demand based indicators. If the stock market is in the midst of a correction, then it will be likely nearing an end once the price presses new lows for the decline with strong positive divergences having been painted out in a number of supply and demand indicators. Some indicators are currently showing marginal positive divergences, but evidence that the price decline to date has caused a washout type bottom has yet to arrive. This implies the probability of lower lows for the decline. Once this decline finds its bottom, perhaps during a newsy type event, then if the positive indicator divergences are still in place, it would be reasonable for a rally to develop,which has the potential to assault new all-time highs. This is the best case scenario, and currently a lower probability.
If the stock market is in the early phase of a newly minted bear market, then what appears to be a correction setup in the previous paragraph,will likely turn out to be only the first leg down in a multi-week,multi-month, or in the extreme case a multi-year bear market. In the bear case the next significant rally will fail to make new all-time highs, and once the now counter-trend rally fails, savvy investors will take notice and begin to sell the rally in size. As recognition spreads among investors that the bull has indeed expired, then the potential for episodes of panic selling will rise,and with it a parabolic rise in risks to accumulated wealth. Mature bear markets are animals to behold as no manner of “good news” can levitate them, and waves of selling interrupted by violent, albeit short lived, rallies become the order of the day.
Investors would do well to remember how bear market mathematics work. For example a fifty percent decline means investors must then make back one hundred percent to get even! And, once unlucky investors are cut in half,they may still be vulnerable to being cut in half again! You don’t believe me,then Google a chart of the Dow from the all-time high on September 3, 1929 at 381.17 to the bottom on July 8, 1932. Count back from the July low to the late winter and early spring of 1932 when the Dow was trading at around 80, and just a few weeks from its bottom at 41 and change on July 8, 1932. After declining from 381.17 that 80 number in the spring may have looked like a bargain, and it was if investors did not mind getting cut in half again! No I’m not suggesting that investors are vulnerable to a disaster on the scale of 1929-32, but I am suggesting that the uncertainties surrounding the potential for wealth destruction during bear markets should compel investors to protect their wealth sooner rather than later.
A long history of a positive seasonal bias from roughly Halloween to Easter, and some indicators displaying budding positive divergences, would seem to imply that the current decline may find a bottom in the days ahead? If the decline ends soon, then the next significant rally will become critical in determining if the stock market is only correcting, or if the market has begun the early phases of a new bear market. The difference between the two is copious amounts of wealth safely banked, or portfolios made vulnerable to the ravages of a bear market due to failure to take defensive action as the warning signs grow stronger.
There are other ways this current weakness could play out, but for now the two candidates outlined above are the most probable. Market analysis is an ongoing detective story for which we get new clues daily, so depending upon the latest clues the probabilities may change.
TATY, a supply and demand indicator, is shown in yellow on the attached chart, and the S&P 500 cash index is shown in red and blue candle chart format.
Gregory H. Adams
Senior Portfolio Manager