In this past weekend’s missive “Market Bounces, Now Execute Sells,” the long consolidation process that began early this year finally resolved itself. Unfortunately, the resolution was to the downside as market stresses from China, the threat of rising interest rates and ongoing economic weakness finally overwhelmed the seemingly impervious bullish sentiment.
While the now “official correction” was not a surprise, and is something I warned of repeatedly over the last several months, it is possible that this is more than just a “buy the dip” opportunity. As I stated last Tuesday:
“Is this something more than just a simple correction? The honest answer is that no one really knows. The bulls are “hoping” that the worst is over and that the current bull market will resume its upward trend. However, there is ample evidence suggesting that something else may be afoot from slowing domestic and international growth, collapsing commodities and falling inflationary pressures.”
But the underlying fundamental and economic data have been weak for some time, yet the market continued its unabated rise. The Bulls have remained firmly in charge of the markets as the reach for returns exceeded the grasp of the underlying risk. It now seems that has changed. For the first time since 2007, as we see initial markings of a potential bear market cycle.
The first chart below shows the long-term trend of the market
The bottom part of the chart is the most important. For the first time since 2000 or 2007, the market has now registered a momentum based “sell” signal. Importantly, this is a very different reading that what was seen during the 2010 and 2011 “corrections” and suggests the current correction may be more significant.
The chart above is also confirmed by numerous other indications that also support the “mark of the bear.”
Importantly, notice that during the 2010 and 2011 corrections, which were ultimately halted by rapid interventions by the Federal Reserve, “sell signals” were never triggered. Currently, those signals have been triggered at levels that have only been witnessed during more severe bear market corrections.
Fed To The Rescue?
The problem for the Federal Reserve is the negative economic impact from a loss of confidence and decline in the “wealth effect” resulting from a significant market decline. During the previous two episodes where shorter-term indicators signaled investor caution, it was shortly met by Central Banker’s interventions to stem a more pervasive decline. In 2010, then Fed Chairman Ben Bernanke stated the Fed’s goal of using monetary policy to inflate assets prices to spur consumer confidence. With the market once again triggering an important “sell signal” will the Fed opt to move forward with a further tightening monetary policy? Or, are we on the verge of the next intervention?
Important Numbers To Watch
In my earlier missive “Previous Warnings,” I detailed some very important levels for investors to watch for.
“What is critically important is that the market rebounds, and holds, above 2026 by the end of this week to keep the bull market advance alive. A failure will likely lead to a test of the long-term moving average at 1825 or a 14% decline from the peak. However, such a decline from current levels, and at this late stage of the cyclical bull rally, would likely blossom into a full-fledged bear market of 20% or more. In other words, if the market fails to hold support at 1825, the decline will be substantially worse as witnessed in both 2000 and 2008.“
The markets did rebound last week, as expected, but failed to follow through this week. The current decline sets the market up for a retest of the recent lows at 1867. Critically, a failure to hold those lows will not only break the bullish trend that started in 2009, but will likely create a “rush to sell” that could drive markets to substantially lower levels.
The risk of such a decline, as stated previously, is at some point the erosion of portfolio collateralization will reach levels that “margin calls” become a substantial risk.
“While ‘this time could certainly be different,’ the reality is that leverage of this magnitude is ‘gasoline waiting on a match.’ When an event eventually occurs, that creates a rush to sell in the markets, the decline in prices will reach a point that triggers an initial round of margin calls. Since margin debt is a function of the value of the underlying “collateral,” the forced sale of assets will reduce the value of the collateral further triggering further margin calls. Those margin calls will trigger more selling forcing more margin calls, so forth and so on.”
It is at those levels that the “wheels come off the cart” leaving investors little opportunity to exit the markets.
What If I’m Wrong
Could I be wrong? Absolutely. With Central Banks globally “at the ready,” there is a real possibility that markets could be surprised by what happens next. I think there is a greater than even chance that the Federal Reserve balks at raising rates in September, and mentions remaining accommodative for as long as necessary, sending the markets into recovery mode.
If the market should re-establish its bullish trajectory, it will simply be a function of re-allocating risk back into portfolios at that time.
Yes, you will miss a small portion of the recovery, but such a “miss” will be far less of a consequence than a potential 20-30% correction if the markets fail.
Remember, our job as investors is NOT to try and beat some random benchmark index, but to grow our savings in a manner that conserves our principal over time.
The reality is that the majority of investors are ill-prepared for an impact event to occur. This is particularly the case in late-stage bull market cycles where complacency runs high. As Dr. John Hussman concluded recently:
“If you’re taking more equity risk than you can actually tolerate if the market goes south, setting your portfolio right isn’t a market call – it’s just sound financial planning. It’s only fun to be reckless if you also turn out to be lucky. Market conditions are now more hostile than at any time since the 2007 peak. If you want to be speculating, and you can tolerate the outcome, then you’re not taking too much equity risk in the first place. But it’s one or the other. Can you tolerate a 40-55% market loss over the next 18 months or so? If not, take this opportunity to set things right. That’s not the worst-case scenario under present conditions; it’s actually the run-of-the-mill historical expectation.”
The discussion of why “this time is not like the last time” is largely irrelevant. Whatever gains that investors have garnered during the recent bull market advance will be wiped away in a swift and brutal downdraft. However, this is the sad history of individual investors in the financial markets as they are always “told to buy” but never “when to sell.”