Bear Market Devil Might Be Lurking in the Details

Originally posted at

I recently completed a Bankrate survey of market analysts. It contained a number of questions, one of which asked to assign a probability of a bear market occurring over the next 12 months. My response was that there was a 35% probability of a bear market occurring over that time, yet I have been left wondering if perhaps my response was too conservative.

No one knows with 100% certainty what the future holds, but could you really say that you'd be completely surprised if a bear market unfolded over the next 12 months? If you're hearing what we're hearing and seeing what we're seeing, the answer would have to be "no."

To make my point, I'll show you several charts, make note of some interesting data points, and highlight some qualitative guidance. First, though, to set the stage, I'm going to tell you a brief story of an au pair experience from hell.

A Stark Reality

My wife and I both work full time. You know what I do, and longtime readers will likely recall me mentioning in a past column that my wife is a clinical psychologist**. We have four children, the oldest of whom is 11.

During the time between the birth of our third child and the arrival of our fourth child, we engaged a service to help us find an au pair, who would live in our home full time in exchange for a stipend and an opportunity to live, and study, in the US We thought it would be a great cultural experience for us and our kids. The au pair we eventually connected with was from South Africa.

Long story short, we disconnected with that au pair about two weeks into her stay after some psychological red flags were waving all over the place that made us painfully aware we couldn't trust her to be alone with our young children. It also became painfully clear that the agency's background check was woefully inadequate.

The kicker for me was when the au pair informed me that she had spoken with the devil — not figuratively, but literally (in her mind anyway).

The added kicker for my wife was when the au pair told us her "mom" was actually her aunt, because her birth mother committed suicide after being unable to handle the stress of caring for small children (neither fact had been disclosed in the interview process nor flagged by the agency).

That was obviously sad to hear, yet my psychologist wife also had a more adept clinical take on matters. To that end, a Johns Hopkins Children's Center study found that young children who lose a parent to suicide have a higher relative risk of committing suicide themselves later in life and/or developing psychiatric disorders than do children with living parents.

With some other disturbing incidents in that brief stay, which I won't elaborate on, it was clear the arrangement wasn't going to work.

Perhaps nothing bad would have happened, but there was no way we were going to take that chance.

For us, the stark reality was this: if we had come home and found any of our kids badly injured, missing, or worse, we couldn't say that we would have been totally surprised. The signs of those risks were there for us to see and it would have been foolish to ignore them.

Some Charts

That brings me to some signs in the market today that are raising some red flags about the US stock market outlook. It's possible that they won't stay red, yet the picture forming now is why the possibility of a bear market unfolding down the road wouldn't be a surprise.

(Note: we're adhering to the generic definition of a bear market as being a drop of 20%, or more, from a high. At the close on Thursday, September 24, the S&P 500 was down 9.5% from its high.)

  • High Yield spreads have risen sharply over the last three months as the continued drop in commodity prices has increased the risk of default activity, particularly for energy and mining companies. Rising high yield spreads have often preceded sharp stock market downturns.

  • The transports have remained weak even as oil and fuel prices have continued to come down. That's surprising knowing that transports have leading indicator status and count fuel as their biggest expense behind labor.

  • Investor angst over the last three months has been palpable on a global basis for reasons that have involved weakening economic growth, currency battles, valuation, uncertainty over monetary policy, and the performance of the stock markets themselves.

  • Foreign currencies have been reeling against the dollar in a reflection of angst about interest rates, economic weakness, and capital outflows. The dollar's strength has been, and remains, a headwind for US multinational earnings prospects.

  • Forget oil for a bit and look at copper, which is a leading indicator given its widespread use in industrial applications and has continued to languish.

Some Interesting Data Points

  • S&P 500 revenues are projected to be down 2.6% in the third quarter, according to S&P Capital IQ. That would be the third straight quarter of revenue declines. Such a string hasn't been seen since 2009 when the world was buried in the financial crisis.

  • 21.6% of S&P 500 stocks are already down 20% or more from their May 2015 high

  • Nine out of ten S&P 500 sectors are down year-to-date. The only gainer has been consumer discretionary (+3.8%). The highly cyclical energy, materials, and industrials sectors are down 22%, 17%, and 11%, respectively

  • Brazil, Russia, and Canada are in recession. Japan's economy contracted in the second quarter. The eurozone economy grew at a 1.3% annual rate in the second quarter, which was slower than the 1.5% growth rate in the first quarter. These nations and the eurozone bloc account for roughly one third of global GDP and are either in recession or hardly growing.

  • Since the start of 2015, there have been 67 policy rate reductions announced collectively by 29 central banks

Some Qualitative Guidance

  • From Caterpillar (CAT): Sales and revenues for 2015 are now expected to be about billion, or roughly .0 billion lower than previously estimated due to broadly weaker business conditions across our three largest segments — Construction Industries, Energy & Transportation, and Resource Industries. 2016 sales and revenues are expected to be about 5% below 2015. 2016 would mark the first time in Caterpillar's 90-year history that sales and revenues have decreased four years in a row (emphasis our own).

  • From HB Fuller (FUL): The primary driver of the lower than expected [third quarter] earnings was lower than expected revenue in the Americas operating segment. Revenue generation in the Americas operating segment is running below prior year levels primarily due to generally weak end market conditions and some residual effects of the Project ONE implementation in North America last year. We are updating our earnings guidance for the 2015 fiscal year primarily to reflect lower revenue expectation in the Americas operating segment and a slightly higher tax rate.

  • From Rockwell Collins (COL): We continue to experience weak market conditions in our business aviation business. At this time, we don't expect to see these conditions improve significantly in the next year so we are re-setting our near-term expectations for that business.

  • From Wal-Mart (WMT): Operating profit will be pressured for the remainder of the year due to continued investments in store associate wages and additional hours, as well as headwinds from pharmacy reimbursements and ongoing shrink, primarily in Walmart US In addition, we continue to be impacted by currency exchange fluctuations.

  • From Nike (NKE): Fiscal 2016 is off to a great start. North America had another great quarter with revenues up 9%, Western Europe revenues grew 14%, emerging markets revenue grew 19%, Brazil revenue was flat, and greater China revenue was up an amazing 30%. At the end of the first quarter, worldwide futures orders for Nike Brand athletic footwear and apparel scheduled for delivery from September 2015 through January 2016 were 9 percent higher than orders reported for the same period last year, and 17 percent higher on a currency-neutral basis (Hey, it isn't all bad out there).

What It All Means

This bull market isn't charging the way that it used to for a variety of reasons. We have talked at length about the reins of uncertainty holding things back, the downward earnings estimate revisions, the headwinds of a stronger dollar in a less-than-robust global economy, stretched valuations, and time itself given the lack of a meaningful correction in four years.

Well, that correction happened in late August and there is a reasonable basis to think it isn't over yet. More to this week's point, though, there's a reasonable basis to think it could go beyond a correction and form into a bear market.

That's not our base case. As noted above, I put the probability at 35%, but if the global economy continues to deteriorate and takes earnings estimates down even further with it, then the probability increases.

For a bull market that hadn't seen a 10% correction in four years, the transition to contemplating the possibility of a bear market has been swift.

[Read: Technical or Structural Bear Market Ahead?]

Perhaps nothing that bad will happen, but are you willing to take the chance?

The signs of risk are there for everyone to see and it would be foolish to completely ignore the devil that just might be lurking in the details (figuratively, not literally).

**The July 19, 2013, article, The Cognitive Dissonance of the Stock Market, is available in the archive for subscribers

About the Author

Chief Market Analyst