Prepare For A Bear Market

January 15, 2016

bear and bulllSummary

Is the market's trading action the first week of the year significant?

The importance of trend lines.

What do secondary indices tell us about the major ones?

In October, I noted that the stock market's cyclical bull market rally, within the secular bear, effectively ended. The Dow made its all-time intraday high on May 19, 2015 and an intermediate low on occurred on August 24, 2015. The August trading action was particularly interesting since the market had not traded in such a wide range (3,000+ points) since the October 2008 meltdown. August's market action gave a great indication about how the market felt. When I say the market, I mean all its participants, both large and small.

Nothing reflects market uncertainty like a large monthly trading range. The trading range also serves as an "attractor" for future prices. That is to say, the future price action of the ensuing weeks, and potentially months, would be constrained within August's range. At no point since August, has the Dow closed, on a monthly basis, above the high set in August. I focus on monthly price action now since that is the broadest indicator I evaluate. At the close of September, my broadest indicator (monthly price action), suggested the end of the cyclical bull market rally. Until such time as there is a change, I will presume the high set last May is significant.

There is also the matter of chart analysis. The graphic below depicts the Dow Jones Industrials going back to the historic 2009 low. I drew a trend line from a major low in 2011 to the present time. The trend line was breached in August and has not been meaningfully surpassed since then. The line serving as market support for four years has now become resistance. I could also draw this line all the way to the 2009 low, though it loses some of its precision, however it still reinforces the same point.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.

Here are some other considerations.

  1. The Dow Jones Utilities Index made its high in January of 2015 and has trended down since.
  2. The Value Line, S&P Small Cap Index, S&P Mid Cap Index, and Russell 2000 peaked in the Spring or early Summer of 2015.
  3. The Dow Jones Transportation index peaked in late December of 2014 and has trended down since. If you subscribe to the Dow Theory of the markets, as popularized by the late Richard Russell, a bear market signal emerged in August of 2015 when both the Industrials and Transportation Index closed below their respective October 2014 lows. There has been a wide divergence between these two indices since August.
  4. The S&P 500 is a weighted index. The larger cap stocks receive more weight. If you evaluate the index such that each stock were to receive the same weight, a different picture develops. Since October, the weighted index has performed better than the unweighted version. This affirms that a few stocks are carrying this index. I also make this point below with respect to the NASDAQ.
  5. According to investment bank, Jefferies, the average stock in the S&P 500 is down 20% or more from its 52-week high.
  6. The NASDAQ 100 did show a nice gain for 2015, despite the large hiccup in August. Were it not for the high flying tech darlings named Apple (NASDAQ:AAPL), Amazon (NASDAQ:AMZN), Facebook (NASDAQ:FB), Microsoft (NASDAQ:MSFT), and Google (NASDAQ:GOOG), the index would have finished with a loss. Amazon is an interesting case. The company lost $241 million in 2014 and yet commands a Price Earnings Ratio of 870. That is not a typo. The ratio for Facebook is a very generous 98. So two out of the five high flyers leading the NASDAQ have PE ratios that by any measure are sky high.
  7. The fascination with technology is further bolstered by Tesla (NASDAQ:TSLA). The company share price increased by 14% in 2015, though they've given most of that back the first week in January. Tesla's PE ratio is undefined since they've lost money going back to 2012.
  8. For those that like to evaluate fundamentals, the Institute for Supply Management (ISM) reported their manufacturing index at 48.2, down from the previous month. Readings below 50 reveal a manufacturing sector in contraction.
  9. Specifically, the ISM index showed employment contracting and customer inventories growing.
  10. A good portion of my writing deals with the topic of deflation. Referring back to the ISM index, manufacturing prices have been in a contracting trend for 14 months.
  11. A similar index in China, the Caxin Purchasing Managers Index, fell again in December and has been below 50 since March of 2015.

The first four trading days of 2016 were among the worst in market history. There is simply too much breadth to the sell-off to ignore the awakening of the bear. In my books, I discuss the concept of investment cones. Excess liquidity ($$$) funnels into these financial asset cones and buoys them. Some might suggest the liquidity lifts them completely out of the water. The cones break down, liquidity dries up, and prices tumble. There is a great deal of financial asset correlation in the credit bubble era. Consider any asset that benefited from the cone effect as being highly vulnerable to deflationary effects. Stocks are but one of the aforementioned cones.

Presently equities appear quite oversold with very low bullish sentiment for futures traders and moderately bearish sentiment for individual investors. It would be quite natural for a brief rally to ensue. Don't confuse the rally or even a new high as a sign the bear has gone into hibernation again. He'll be back.

Jim Mosquera is the author of E$caping Oz: Navigatingthe crisis.  This is a successor to his previous book, E$caping Oz: Protecting your wealth during the financial crisis. Jim is a Principal at Sentinel Consulting a business restructuring and capital acquisition firm geared towards small to mid-sized businesses. He operates the financial and economic site The Sentinel. You can email him here: jim@thesentinel.biz

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