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Is a Major Correction and Bear Market Around the Corner?

Predictions of a major stock market crash are a dime a dozen in the financial news business. With the current U.S. bull market now five years old, margin debt levels at record highs, and stocks trading at elevated levels, calls for a major crash or bear market have been growing.

In a recent interview with Financial Sense Newshour, PFS Group’s Chris Puplava says the most reliable warning signs for this to happen simply aren’t there...yet.

What are these warning signs, you ask? According to Puplava, they are: the onset of a recession and/or a deterioration in the credit markets. He says:

“The two primary causes of a bear market are either an economic recession or some kind of financial crisis… Generally, credit conditions deteriorate and you can get a financial panic; and you don't necessarily have to get a recession from that, but the panic in financial markets and credit markets is enough to lead to a bear market. But, traditionally, most bear markets occur because of a recession. So, those are really the two areas that I monitor: number one, what's the probability of a recession on the horizon and then, number two, what is the health of the credit system?”

With regards to the economy and its influence on the market, Puplava aggregates a wide range of economic data, and then tracks the probability of a recession over time. Currently, when looking at the most recent data, he says there is “very little risk of a recession this year.”

To be exact, his recession model (shown below) calculates a 9% probability of an imminent recession, with anything above 20% separating the noise of a potential economic crash from the real deal.

Without being able to monitor this continually, he says, it would be very easy to get caught up in a panic and think the economy is about to implode just by reading the news every day. “Since 2009, not once has it gone back above that 20% threshold, which has helped me ignore a lot of the noise and stay on the right side of this market.”

Source: Bloomberg

The second area Puplava says he monitors regularly is the health of the credit markets. He explains:

"The credit market, in my opinion, is kind of the boots on the ground in terms of the financial markets. If you think about banks, they have a very keen eye on the economy. They're the ones making loans to businesses, to consumers—they make loans to other banks—and so when they begin to get a little uneasy, they require higher interest rates. This leads to rising interest rates relative to a risk free rate like the treasury and you begin to see those spreads widen just before a recession."

Puplava cited a couple of times during this bull market—in 2010 and 2011—how credit conditions started to tighten around the globe and there were many fears that the market was going to unwind again; but, each time, the credit markets stabilized and signaled that we were just going through a normal correction.

When looking at the credit markets today (see the Bloomberg US Financial Conditions Index below in red, S&P 500 in black), he says they are “very calm” and “not showing any signs of stress as they have in the past.” “That’s a little surprising to me because I thought once the Fed would begin to taper QE and throttle back on the liquidity it’s injecting into the system, you might begin to see a little pickup in volatility,” Puplava said. So far, that hasn't happened.

Source: Bloomberg

In addition to economic activity and overall credit market strength, Puplava also likes to monitor corporate profit margins, which have peaked and signaled trouble before every single recession for the last 50 years. Today, he says, they’re at all-time highs. Until corporate profit margins shrink, the credit markets show signs of stress, and the risk of a recession increases, Puplava says the probability of a major peak or bear market crash at this point still remains low.

So, are there any warning signs on the horizon? Puplava says:

"If anything I would say we're either due for some kind of consolidation as evidenced by a loss in momentum or we do have the potential for a correction. That's always the case whether you have a potential bear market on the horizon or a recession. The frequency of corrections is much greater than bear markets so there's always that possibility. Things could unravel with Ukraine and Russia. That could lead to some instability. You might have another economic soft patch like we had in the first quarter and maybe we have that down the road. There’s always that potential. But you can't really forecast the future and tell the market what it’s supposed to do; you can only look at what the data is and what's the probability of various outcomes. And when I look at that, I don't see a high probability the market is peaking here."

Chris Puplava, Portfolio Manager at PFS Group, can be contacted at 888.486.3939 or by email at chris.puplava @ financialsense.com.

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