Economically, the beginning of 2016 was pretty frightening to say the least.
Markets around the world, including those in the U.S., saw the worst start to a year since 2001 and the sixth worst of all time.
Combine this with the political turmoil in the Middle East, plummeting oil prices, Brazil’s implosion, China’s drastic slowdown, and H-bomb activity in North Korea, and we pretty much have a perfect recipe for a bear market.
By definition, a bear market is triggered by a downturn of 20% or more in multiple market indexes over the course of two months or more. (That “two months” part is important, since bear markets should not be confused with more rapid correction movements.)
So in reality, we’ll have to wait until February/March to really determine whether 2016 has brought a bull or bear market.
However, when the market closed last week, more than 200 of the stocks on the S&P 500 were down at least 20% from their 52-week highs.
At the beginning of this week, the average U.S. stock was already down 20%. The NASDAQ is down 11% from its peak in 2015, followed by the DJIA and S&P, both down 10.7% and 9.8%, respectively.
More generally, a bear market is characterized by falling securities prices and a general feeling of pessimism towards the market, which is why it shouldn’t come as a surprise that events in the past few weeks have caused headlines to be flooded with fears of an impending bear market and overall slowdown.
However, if you’ve visited Pro Trader in the past, you know that we’re big supporters of practicing skepticism. Basically, don’t believe everything you hear.
Despite the array of negative indicators, experts at Morgan Stanley still maintain that the United States will weather this economic storm. In fact, the most optimistic of the group believe that the U.S. will actually continue to experience significant growth throughout 2020.
“That would make the much-criticized recovery from the Great Recession the longest U.S. expansion in the post-war period.” — CNN Money
With that, let’s take a closer look at some of the evidence circulating throughout the financial sector in order to determine whether or not this impending bear is really on the way…
Da’ Bears
Activity on the first trading day of the market has been repeatedly used as an indicator for movements in the year to come. Generally, if the market declines on the first day of trading, then investors expect an overall decline for the following 12 months.
…Sometimes.
Results of the first day of trading have only served as an accurate predictor of future activity ~50% of the time. With those odds, you could toss a coin and produce the same accuracy of data.
For the sake of preserving the integrity of statistics, let’s all agree that “omens” like this one only warrant attention if/when they can be supported with additional information.
In this case, we mean something like China’s slowdown (read: crash) and also the overall sluggishness of manufacturing worldwide. Before 2008, China’s growth was driven by productivity. Since then, that growth has slowed significantly, as it became dependent on investment. Due to inefficient misallocation of capital, China’s total factor productivity remains about 40% of the U.S. level.
The IMF forecasts that China’s growth will slow to 6.3% in 2016 and 6% in 2017. Although this rate remains competitive by international standards, it’s much lower than previous expectations.
At this stage of an economy (when nations are intrinsically entwined), the situation in China has a direct effect here at home. Like we mentioned before, when Chinese markets shut down in the first week of 2016, global markets felt the fallout. Over the course of 2015, the country’s foreign reserves fell by more than $500 billion.
Those events have led many economists to believe that the Fed shifted monetary policy too early. Last week, most experts slashed their Q4 growth estimates for the U.S. by an average of 200 points — down to barely more than 1%.
Even further, the basic economic forces of supply and demand are pointing to conditions that, over the past 88 years, have directly correlated with significant market tops. Buying power loses points as selling power gains points, skewing the necessary equilibrium.
This contributes to stock overvaluation.
By several measures, stocks are still currently overvalued by a range of 75% to 100%, despite recent plunges in the market.
The graph below shows the last two times we saw overvaluation like this:
This chart illustrates the ratio between total U.S. market capitalization of all shares outstanding and the GDP, the historical average of which is 50%.
A 100% ratio means that the total market cap is equal to the nation’s GDP. In this case, the stock market would be considered fairly valued. An undervalued stock market would produce a ratio less than 100%, therefore the opposite for an overvalued market. A good rule of thumb? Tread lightly whenever the ratio exceeds 100%. It’s a good sign that the market is overdue for a correction.
Take note of two things here. You probably can’t miss them, because there are two large red arrows pointing in their direction.
The first is the dot-com bubble of 2000. The second is in 2008: the housing bubble.
Between 1996 and 2000, dot-com companies saw their stock prices soar. The NASDAQ exploded from 600 to 5,000 points. In 2000, the market cap-to-GDP ratio reached 146%, an all-time high. Poorly managed companies with no hope or history of earning profits had market capitalizations of more than a billion dollars. (Anyone remember Pets.com?) In the end, a total of almost $8 trillion of wealth was lost.
In 2008, the ratio reached 108%. This bubble came suddenly, as a combination of stock overvaluation and the collapse of the housing market. In just five months, the DOW fell 20%, from historic highs of 14,000 to just over 7,000.
I don’t want to bring back nightmares for anybody, but the series of events that followed nearly pushed our entire global economy off a cliff.
Right before both of these bubbles burst, stocks were clearly overvalued. In fact, right before essentially every market correction, the U.S. market cap-to-GDP ratio has been over 100%.
You make the connection.
If China’s bleak outlook, combined with the Fed’s mistiming and overvalued stocks, isn’t enough to convince you, then let’s check out commodities.
The last time we saw commodities prices this low was just a few months before the crash of 2008.
Most recently, the Bloomberg Commodity Index reached its lowest levels since 1999.
Times are particularly tough for metals and mining companies, which have been slammed by the slowdown in China and elsewhere.
Some larger mining firms have already sold off more than half of their assets. Others have suspended dividends and slashed jobs by the thousands.
No one likes to be the bearer of bad news, and everyone wants the bull market to continue…
Unfortunately, it looks like this time the headlines just might be right.
{$custom_ptt_jessica_signoff}