My most recent blogs – August 10 and August 11 – highlighted the unprecedented volatility that has characterized the U.S. stock market over the past year. I concluded that “…the potential for a major market collapse increases.”
The market took out a down payment on such a collapse with its 1100 Dow freefall in the opening minutes of Monday, August 24. The opening hardly marked the end of the excitement, however, as prices rocketed back and forth until the closing bell. In total, there were 17 moves in opposite directions ranging from 100 to 1100 points. On average, the market changed direction every 23 minutes, with each price move averaging 335 points. That action would have constituted a busy quarter, but it unfolded in a single day. High frequency traders must have had a field day.
While that frenetic pace couldn’t continue, even the reduced volatility remained extreme by virtually any other yardstick. Tuesday through Friday, August 25-27, saw 26 additional alternating price moves ranging from 100 to 450 Dow points. For the four-day period, prices moved an average 263 points in alternating directions every 36 minutes. Although volume was the highest in four years, there were probably not a lot of long term investors. Perhaps more long-term investors should have been involved. With equity holdings very close to their maximum levels seen before the perilous market collapses beginning in 2000 and 2007, serious damage to shareholder wealth will unfold if a bear market has in fact begun. Numerous conditions indicate that a bear market has probably begun. The depth and duration remain to be seen.
Substantial publicity attended last week’s “death cross” on the S&P 500, with that index’s 50-day moving average dipping below its 200-day moving average. As always, when such a phenomenon occurs, naysayers emerge to point to instances in which the cross did not predict a severe market decline. What is more important to recognize, however, is that more often than not, such a cross does introduce a significant market decline.
The Dow Jones Industrial Average demonstrated the same pattern a few weeks earlier than did the S&P. Around the world, the picture is convincingly the same. We follow activity in 46 world markets. Every one of them is trading below its 50-day moving average, and only four are trading above their 200-day moving averages. Most world markets show losses for the year-to-date, and their moving averages are declining. Price destruction is widespread.
When U.S. stock markets have risen intermittently over the past year, leadership has come from fewer and fewer stocks. Among operating companies, only 2% to 3% of stocks are trading within 2% of their 52-week highs. On the other hand, more than half of such companies are trading 20% or more below their 52-week highs. Far more issues are reaching 52-week lows than 52-week highs.
For many months, the number of stocks rising relative to the number declining has diminished substantially with the trend accelerating recently. The deterioration started in the small-cap area, graduated to mid-caps and has recently spread to large-caps–a classic pattern leading to a bear market.
A well-respected old saying in the investment industry is that volume confirms price. As indicated earlier, volume picked up markedly on last month’s precipitous price decline. In a process begun more than two years ago, volume going into rising stocks has deteriorated steadily relative to volume going into declining stocks. Over the past few weeks, the cumulative volume total going into declining stocks has surged above the volume going into advancing stocks. As measured by Ned Davis Research since 1981, the S&P 500 has on average declined when that condition has prevailed, and the index has performed an annualized 13.5% worse than when advancing volume has dominated.
The highly respected Lowry Research Corp., providing excellent technical analysis since the 1930s, computes buying power and selling pressure as its primary measures of supply and demand on an intermediate to long-term basis. Its current computation indicates the 6½-year bull market to be in its final phase. Two weeks ago, Lowry’s identified a condition related to buying power and selling pressure that has existed only five other times since the 1930s. All occurred in significant market declines, although two were identified toward the end of those declines and only a few percent above the ultimate bottom. The other three signals were followed by declines of 44%, 40% and 32%. Needless to say, precedent suggests that investors pay attention.
For the past year and a half, the yield on lower quality debt has been rising notably both absolutely and relative to U.S. Treasury securities. That condition has preceded some of history’s most costly equity declines.
The venerable, old Dow Theory issued a bearish signal last month, as both the Dow Industrials and Transports closed beneath their October 2014 lows. And the Elliott Wave, as interpreted by Elliott Wave International, forecasts lows in this country not seen since the 1940’s. For that to be correct, we would almost certainly have to experience a worldwide depression–an out-lier call, to say the least.
Technical conditions are by no means alone in raising storm warnings. Worldwide fundamentals are similarly uninspiring. The International Monetary Fund (IMF) and the Organization for Economic Cooperation and Development (OECD) have each continued to drop their forecasts for both US and world GDP growth. They have characterized the growth rates as weak and worsening. Similarly our Federal Open Market Committee has had to drop its domestic GDP growth estimates. There are pronounced growth declines and/or outright weakness in China, Canada, Brazil, Russia, South Africa, Japan, Taiwan, Singapore and South Korea – representing many different parts of the world with very different characteristics. Economic weakness is widespread.
The European Central Bank has recently cut its outlook for inflation and growth for 2015, 2016 and 2017. Those projections were made before the most recent China problems bubbled to the surface. Just last week, ECB head Mario Draghi stressed that renewed downside risks had emerged.
Emerging markets have been increasingly distressed by U.S. dollar strength, by commodity deflation and by China’s surprise devaluation. In an attempt to defend their individual economic well being, a growing number of emerging countries have devalued their currencies. The risk of widespread currency wars is expanding. The Financial Times recently reported that these currency devaluations had failed to stimulate exports and had, in fact, diminished world trade. Because so much of emerging-market debt is denominated in U.S. dollars, dollar strength is exacerbating the repayment burden. And that burden will get heavier still when our Federal Reserve eventually begins its interest-rate normalization process.
Domestically, corporate earnings are weak and will likely be down in calendar 2015 from 2014. Analysts have for several years been forecasting significant earnings growth for the year ahead. Those forecasts have been far too optimistic, however, and have been ratcheted down progressively as each quarter has drawn near. With S&P 500 GAAP earnings barely up in 2014, earnings by the end of this year will be approximately flat from two years earlier. If stocks were cheap, that might not be a great problem. As we have highlighted in any number of this year’s blogs, quarterly reports and seminars, however, a composite of all major valuation measures shows stocks to be more overvalued than ever before, but for the months surrounding the dot.com peak in 2000. Returns from valuation levels even far below current levels have been substantially below normal over the decades.
As we have written frequently for the better part of the past two decades, debt burdens have grown to unprecedented levels relative to the size of economies throughout the world. The debt problem was a critical ingredient in each of the two 50%-plus market collapses of the past 15 years. Today’s level of debt, far worse than in those earlier instances, raises the risk of extreme market and economic reactions should those debts begin to unravel. It creates the risk that a traditional market decline could turn into something far more severe, especially if investors should lose faith in central bankers’ willingness and ability to keep economies and markets afloat. It is instructive to reflect on the June warning by the Bank for International Settlements (the central bank for the world’s central banks) that central banks are now virtually out of ammunition to deal with either a major market crash or a sudden world downturn.
We find the evidence compelling that a bear market has very likely begun. That does not rule out attempts by markets to rally back toward recent highs, such as today’s 390-point rally, especially given the market’s short-term oversold condition, but it makes it unlikely that further gains will be sustained. The danger looms that a market, economic, political or military event could decimate investor confidence and lead to a persistent, destructive decline.
The primary hope for a more sanguine outcome lies with central bankers. History’s most massive stimulus efforts have supported stock and bond prices for 6½ years, with little tolerance for even minimal declines. The IMF is currently calling on the ECB to expand its quantitative easing program, and it recently indicated its belief that Japan may likewise have to expand its program. More than once, the IMF has urged the Fed not to begin interest-rate normalization until 2016 at the earliest. This afternoon the Chief Economist at the World Bank warned that an imminent US rate hike could wreck “panic and turmoil” on emerging market countries. That these two world bodies continue to lobby for governmental support after 6½ years of unparalleled stimulus indicates their recognition of perilous underlying conditions throughout the world.
Many still believe that governments remain in control of markets. However, worldwide price declines over the past few months have to call that belief into question. And the two-month loss of more than one-third of the value of Chinese equities despite unprecedented government intervention should be exhibit A demonstrating that traditional investment factors will ultimately overcome even the most egregious governmental interference.
With so many caution flags waving, individual investors, even those with long time horizons, should evaluate carefully how much they want to leave exposed to equity risk. Institutional investors with permanent equity allocations should explore hedging alternatives. With many of the financial crisis’s problems merely papered over, not solved, a bear market in the years ahead could be deep and lengthy. And there might well be no rapid recovery with central bankers’ arrows already having been fired.