Stock markets are forever cyclical, an endless series of alternating
bulls and bears. And after one of the greatest bulls in US history,
odds are a young bear is now gathering steam. It is being fueled by
record Fed tightening, bubble valuations, trade wars, and mounting
political turmoil. Bears are dangerous events driving catastrophic
losses for buy-and-hold investors. Different strategies are
necessary to thrive in them.
This
major inflection shift from exceptional secular bull to likely young
bear is new. By late September, the flagship US S&P 500
broad-market stock index (SPX) had soared 333.2% higher over 9.54
years in a mighty bull. That ranked as the 2nd-largest and
1st-longest in US stock-market history! At those recent all-time
record highs, investors were ecstatic. They euphorically assumed
that bull run would persist for years.
We
humans naturally extrapolate present conditions lasting way out into
the indefinite future. But long centuries of stock-market history
have painfully proven that no bull lasts forever. Eventually
they all lead to inherently-unsustainable fundamental, technical,
and sentimental excesses. These can only be bled away and
ultimately normalized by bear markets. So bull markets have always
been followed by bears.
Bulls and bears are easily defined technically, 20%+ SPX moves
uninterrupted by opposing 20%+ moves. The greatest stock bull in US
history was the SPX’s 417.0% run over 9.46 years between October
1990 to March 2000. That climaxed in the tech-stock bubble, when
wild optimism about stock-market fortunes reigned. Yet that soon
gave way to tears as the subsequent bear mauled the SPX 49.1% lower
in 2.6 years!
Stock investors suffering their wealth getting cut in half is
typical in major bears. But the losses extend well beyond capital
into far-more-scarce time. After that turn-of-the-century
secular-bull peak, the SPX wouldn’t power decisively above those
levels again until 12.9 years later in early 2013! That’s nearly a
third of the 40 years average investors have between the ages of 25
to 65 to generate wealth to finance retirement.
If
you can’t afford to lose half your stock-market wealth, and you
don’t have time to wait for well over a decade for stock prices to
fully recover, you better take this quarter’s market developments
very seriously. Something snapped in the US stock markets in
early Q4’18, and the price action and volatility since reeks of a
young new bear. While that diagnosis can’t be certain until the SPX
falls 20%+, the signs are ominous.
As
Q4’18 dawned, the US Federal Reserve ramped its
quantitative-tightening campaign to full speed. QT is necessary to
start unwinding 6.7 years of quantitative easing ending in October
2014, during which the Fed conjured $3625b out of thin air to
monetize bonds! QE was considered necessary to stimulate the
economy after the Fed
forced interest
rates to zero in December 2008 during the first stock panic in a
century.
Those trillions of dollars of QE capital injected by the Fed
directly
levitated the stock markets, artificially inflating an
already-mature bull market to monstrous proportions. All those
bonds accumulated on the Fed’s balance sheet, which skyrocketed 427%
higher over that relatively-short QE span! The Fed can’t maintain
$3.6t of bonds on its books forever, so it finally started letting
them gradually roll off at maturity in Q4’17.
That
unprecedented QT capital destruction started small, but was
ratcheted up each quarter until Q4’18 when it reached its terminal
velocity of $50b per month. The SPX achieved its latest
all-time record high in late September, and then October was the
first month ever of full-speed QT. The QE-levitated stock markets
wilted under this QT onslaught, which was inevitable sooner or
later. I warned about all this in advance.
Just
a week after the SPX peaked in late September, I published one of my
most-important essays ever. I unambiguously titled it “Fed
QT is Bull’s Death Knell”, and it explained the stock-market
impact of Fed QE in depth and why full-speed QT was certain to
slay this bull. With the SPX just 0.6% under its recent record
high on that final day of Q3’18, that warning fell on deaf ears.
Maybe investors will pay attention now.
Fed
QT is no flash in the pan, it is a long-term persistent threat to
these lofty stock markets. In order to merely unwind half of that
unfathomable $3.6t of Fed QE, full-speed QT at $50b per month will
have to run for 30 months starting in Q4’18. Heading into
2019 the stock markets face another 27 months of this! And the Fed
is loath to slow or stop its QT now underway on autopilot, as that
could unleash panic-grade selling.
The
Fed has long asserted the reason it is undertaking QT and has hiked
rates 9 times since December 2015 is the US economy is strong. It
wants to rebuild easing-ammunition stores to use in the inevitable
coming recession. If the Fed caves on QT before its balance sheet
shrinks much lower, traders will assume the Fed fears the US economy
is in serious trouble. So they would flee stocks pummeling
them far lower.
The
die is cast on Fed QT, guaranteeing the long-overdue next stock
bear. And the losses seen so far are just a small vanguard of
what’s to come. This first chart superimposes the mighty SPX bull
of the past decade on its so-called fear gauge, the VIX S&P 500
implied-volatility index. The recent Q4 trading action in both is
unlike anything yet seen in this entire bull. It is looking
far-more bear-market-like in character.
Major stock-market selloffs are defined based on size. Anything
under 4% isn’t worth classifying, it is just normal market noise.
Then from 4% to 10%, selloffs become pullbacks. In the 10%-to-20%
range they grow into corrections. And of course beyond that at 20%+
they are in formal bear-market territory. This selloff snowballed
darned close to beardom on Christmas Eve, the SPX plunging to a
19.8% loss over 3.1 months!
Just
4 trading days earlier before the latest FOMC decision, it was only
down 13.1%. While that latest Fed rate hike was expected, the
future-rate-hike outlook among top Fed officials wasn’t dovish
enough for stock traders. Despite all the market carnage since
the previous dot plot, their effective forecast for future rate
hikes was merely lowered from 4 more to 3. So the SPX plunged 7.7%
over the next 4 trading days!
Even
before that this selloff hasn’t behaved like a normal bull-market
correction. Their purpose is to vent excessively-bullish sentiment,
rapidly bleeding off greed. Sharp selloffs are necessary to do
that. Traders don’t get worried until stocks fall fast enough and
far enough to shatter their complacency. So normal bull-market
corrections are usually front-loaded with sharp selloffs that
trigger soaring levels of fear.
Prevailing fear levels are inferred by the VIX, which technically
measures the implied volatility in 1-month SPX options. Before last
peaking in late September, the SPX suffered 5 bull-market
corrections within its epic secular bull. Heading into July 2010
the SPX fell 16.0% in 2.3 months. That spawned some real fear, as
evident in the VIX soaring to a 45.8 peak. The effective fear
ceiling outside of panics and crashes is a 50 VIX.
The
next SPX correction cascaded 19.4% lower over 5.2 months ending in
October 2011. Despite its long span, the VIX skyrocketed as high as
47.5 in its midst. That was real fear, the kind necessary to slay
exuberant greed and rebalance sentiment to keep an ongoing stock
bull healthy. After that the SPX went a near-record 3.6 years
without a single correction-grade selloff in an extraordinary
levitation driven by the Fed.
That’s when its unique open-ended
third
quantitative-easing campaign was in full swing. QE3’s peak year
was 2013 which saw the Fed monetize a staggering $1020b of bonds!
The SPX soared 29.6% higher that year on such vast liquidity
injections. But 2014 saw QE bond buying collapse to $450b as the
Fed tapered QE3. The SPX only rallied 11.4% that year, its gains
shrinking 62% in proportion with QE3’s 56% decline.
The
QE3-goosed stock markets wouldn’t correct again until well after QE3
ended, the SPX sliding 12.4% over 3.2 months into August 2015.
Again the VIX surged to 40.1, which is up in the very-high fear
zone. The next debatable correction followed right after. The SPX
didn’t achieve new highs after the previous one, so it was
technically one compound correction instead of two separate
ones. Analysts render it both ways.
That
second correction or second part of the longer one saw the SPX fall
13.3% over 3.3 months into February 2016. That was the only
bull-market exception that didn’t see a high VIX, it merely climbed
to 28.1 at best. But since the VIX had just recently surged over 40
in a fear climax, another one apparently wasn’t necessary. That
rolling-over SPX action into early 2016 actually looked more
bear-like than bull-like.
Provocatively it took fully 13.7 months after that May 2015
topping for the SPX to finally hit new highs confirming its bull was
alive. The thing that short-circuited what felt like a young bear
was hopes for more European Central Bank easing after the UK’s
surprise Brexit vote in late June 2016. Then the SPX again exploded
higher in November 2016 after Trump’s surprise presidential victory
with Republicans controlling Congress.
Optimism and greed exploded on hopes for big tax cuts soon, fueling
a powerful stock-market surge into early 2018. The SPX then
corrected sharply into early February with a 10.2% plunge in just
0.4 months. The VIX shot up to 38.8 on that, showing real fear.
All bull-market corrections with the lone exception of the second
part of that compound one exhibited telltale fear spikes
averaging VIX peaks way up at 43.1.
But
the recent SPX selloff of Q4’18 coinciding with the first-ever
full-speed Fed QT looks way different. It has been mostly an
orderly, gradual selloff generating modest fear. The highest
VIX close between late September and pre-FOMC in mid-December was
merely 25.8! Even on Christmas Eve it only hit 35.8. These are too
low for normal sharp bull-market corrections, this fear profile is
looking more like a bear downleg.
While bull-market corrections are supposed to shock and scare,
bear-market downlegs start more subtlety. Instead of plunging fast
then stabilizing, bear selloffs start slow then gather steam later.
Bears begin in stealth mode, only gradually rolling over to
prevent fear from spiking. Without big fear to wake them up and
scare them out, investors complacently stay deployed as their losses
slowly and inexorably mount.
Like
the proverbial frog slowly being boiled alive, investors don’t
realize the peril their capital is in during bear markets until way
too late. The lack of normal bull-market-correction fear spike
during this latest correction-grade selloff disturbingly suggests
a new bear has awoken. And coming after such a massive and
largely-artificial QE-inflated stock bull, the fearsome bear QT has
to spawn should be proportionally large.
On
Christmas Eve the SPX was forced close to a 20% bear-cub loss at
2345. That level was first seen in February 2017, and represents
nearly 3/4ths of the post-Trump-election taxphoria rally being wiped
out. 30% would drag the SPX back down to 2052, which were November
2014 levels right after the QE3 bond monetizations ended. 40% would
crush the SPX to 1758, back to October 2013 levels killing 4.9 years
of gains.
But
after one of the biggest and longest stock bulls in US history, it
would be shocking if the subsequent bear didn’t lop off at least
50%. Especially given this bull’s artificial QE-inflated nature
in an era where QE-conjured capital is being destroyed by QT. A 50%
SPX loss from late-September’s peak would leave it at 1465. Those
levels were first seen in this bull all the way back in September
2012, 6.0 years earlier.
While a 50%+ bear warning may sound sensational or overly dramatic,
it’s actually fairly conservative. The SPX already suffered two
bear markets since the tech-stock bubble peaked in March 2000. The
first one ending in October 2002 mauled the SPX 49.1% lower over 2.6
years. The second one climaxing in the first stock panic in a
century drove a far-worse 56.8% SPX decline in just 1.4 years ending
in March 2009.
50%
bears are totally normal after large bulls, even when they don’t
have the amplifying dynamics of the first-ever colossal-scale Fed QE
and QT. This overdue next bear has a great chance of growing
bigger than normal after such a monstrously-grotesque bull.
Most investors won’t figure this out until too late. Unlike
bull-market corrections, high-fear VIX spikes soaring into the
40-to-50 range don’t ignite until later in bears.
While the extreme Fed tightening under this unprecedented full-speed
QT campaign could easily drive a major stock bear alone, so could
excessive valuations. When the SPX peaked in late September, its
500 elite stocks were collectively trading at
literal bubble
valuations! Extreme valuations are what usually cause stock
bears, which exist to force stock prices back into line with
corporations’ underlying earnings.
The
classic honest way to measure valuations is through
trailing-twelve-month price-to-earnings ratios. These take
companies’ last four quarters of actual hard GAAP earnings,
add them up, and divide them by companies’ prevailing stock prices.
Unlike fictional forward earnings, real past results aren’t mere
guesses about the future. Over the past century and a quarter or
so, the US stock markets averaged a 14x TTM P/E.
That’s long-term
historical fair value, which is logical and reasonable. The
reciprocal yield of 14x is 7.1%, an interest rate that is mutually
beneficial to both pay and be paid for investment capital. Twice
that at 28x earnings is the formal bubble threshold. As of the end
of September just after the SPX peaked, its elite companies averaged
a TTM P/E well into bubble territory at 31.4x earnings. They
were dangerously overvalued.
This
next chart looks at average SPX valuations in TTM P/E terms over the
past couple decades or so. The 500 SPX components’ simple-average
P/E is rendered in light blue. The dark-blue line shows it instead
weighted by companies’ market capitalizations. The SPX is
superimposed over the top in red, while a hypothetical fair-value
SPX at 14x earnings is shown in white. This valuation picture is
ominously damning.
The
bubble valuations around the SPX’s late-September peak were nothing
new. They had been above that 28x threshold continuously for 14
months since July 2017. Stocks were already expensive before
Republicans swept the November 2016 elections kindling those
exuberant big-tax-cuts-soon hopes. But they got a lot more
expensive after that as stock prices soared way faster than
corporate earnings since.
Again excessive valuations are what normally spawn stock bears.
Stock prices get bid up too fast during bull markets for underlying
earnings to justify. So bears follow bulls to drag stocks lower or
just sideways for long enough for corporate profits to catch up with
prevailing stock prices. These mean reversions after large bulls
usually see valuations overshoot towards the opposite extreme
before bears give up their ghosts.
So
odds are this young stock bear won’t head back into hibernation
until the stock markets’ average TTM P/E ratio per the elite SPX
components actually falls under 14x. Major bears usually
bottom with the SPX P/E in the 7x-to-10x earnings range, the former
being half fair value when stocks are very cheap and screaming
buys. Late in the last stock bear climaxing in March 2009, the
SPX’s TTM P/E slumped to 12.6x.
But
let’s be conservative and just assume this next bear, even with Fed
QT, merely mauls stocks long enough to force a fair-value 14x P/E
with no overshoot. Assuming corporate earnings don’t grow much
which is a real possibility during a serious stock bear, that
implies 51% downside from the SPX’s late-November levels. That
was the latest month-end valuation data available when this essay
was published.
Historical fair value sans earnings growth implies a bear-market
bottom near SPX 1356, or 53.7% under late September’s peak! That’s
right in line with historical major bear markets, nothing unusual.
As bears generally last a couple years or so, modest underlying
corporate-profits growth could lift that valuation-based bottoming
target maybe 10% or so. That still implies a 49.1% total bear which
isn’t to be trifled with.
The
combination of wildly-unprecedented full-speed Fed QT slamming
QE-inflated stock markets trading at bubble valuations is incredibly
menacing. Seeing bear-market-like rolling-over selling behavior
without big fear spikes in recent months strongly argues the overdue
bear has awoken. But since all that selling has been concentrated
fully within a single quarter, odds are most investors don’t
realize how bad things are.
The
biggest group of investors with the most capital are casual
retirement investors who don’t closely follow the markets. They
avoid much work and stress by paying other people to manage their
money. These investors get statements showing their portfolios’
fortunes after every calendar quarter. At the end of Q3’18,
everything still looked awesome with the SPX just 0.6% under its
all-time high of a week earlier.
So
the Q4’18 statements due out in January could prove shocking,
spawning fear and galvanizing bearish psychology. The
most-widely-held stocks in investment funds are the biggest and best
ones led by the market-darling mega techs. While they were
radically
overvalued at the end of Q3, no one cared at that point.
Everyone owned the largest US stocks including Apple, Amazon,
Microsoft, Alphabet, and Facebook.
Add
in the last FANG Netflix, and these 6 stocks alone commanded over
1/6th of the entire market cap of the SPX just before the Q4
selling started! Their average TTM P/E was a scary 80.2x earnings,
2.6x the entire SPX’s. Yet these beloved companies were believed to
have such amazing businesses that they should be immune to economic
slowdowns or stock-market selloffs. That myth was obliterated in
Q4.
This
SPX selloff first hit 10%+ correction territory on Black Friday with
a 10.2% loss from its peak. On that same day, mighty Apple, Amazon,
Microsoft, Alphabet, Facebook, and Netflix had collapsed 25.8%,
26.4%, 10.8%, 19.9%, 39.4%, and 38.2% from their recent all-time
highs! They averaged 26.8% losses, or 2.6x the SPX’s. Many
if not most investors’ Q4’18 portfolio results are going to look
even worse than the SPX.
Will
they start fleeing and adding to the selling pressure when these
gaping holes in their precious capital are revealed? And while
record Fed tightening and a mean reversion lower out of bubble
valuations are the primary bear-market risks, they aren’t the only
ones. The trade wars between the US and China and other countries
are intensifying, and US political turmoil will soar next year with
Democrats controlling the House.
The
epic corporate stock buybacks that helped levitate the stock markets
in recent years will wane as the Fed forces interest rates higher.
Trillions of dollars of these buybacks were debt-financed
over the past decade. And as stock markets fall, Americans will
feel poorer and spend less. This negative wealth effect will really
weigh on record corporate profits, potentially driving them lower
forcing valuations even higher.
The
Fed’s QT isn’t the only howling central-bank headwind stock markets
face. The European Central Bank is also halting its own massive QE
bond monetizations starting in January! That will suck even more
capital out of the system. Many of these bearish factors for stocks
feed on each other too, with all combined wreaking more havoc on
sentiment and stock prices than individual ones ever could in
isolation.
Investors really need to lighten up on their stock-heavy portfolios,
or put stop losses in place, to protect themselves from this young
bear market. It’s only just beginning, with sub-20% SPX losses at
worst a far cry from 50%+. Cash is king in bear markets, since its
buying power grows. Investors who hold cash during a 50% bear
market can double their stock holdings at the bottom by buying back
their stocks at half-price.
Put
options on the leading SPY S&P 500 ETF which perfectly mirrors the
SPX can also be used to hedge downside risks. But options trading
is risky, with 100% losses possible if the timing doesn’t work out.
And cash doesn’t appreciate in value. So the best bear-market
investment is gold, which tends to rally on
surging
investment demand as
stock markets
weaken. Gold investment grows wealth during stock bears.
Gold
surged 30% higher in essentially the first half of 2016 in a new
bull initially sparked by those late-2015 and early-2016 SPX
corrections. Investors fled burning stocks and flocked to gold.
And the gold miners’ stocks really leveraged those gains, rocketing
151% higher in that same timeframe. The gold stocks are not only
wildly
undervalued, but
just breaking out
technically which should accelerate their upside.
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The
bottom line is a young stock bear sure looks to be awakening. Q4’s
rolling-over stock-market selling without big fear spikes is
ominously classic bear-market behavior. And after such a monster
bull, the next bear is long overdue. Unprecedented full-speed Fed
QT colliding with bubble-valued US stock markets artificially
inflated by long years and trillions of dollars of Fed QE can’t end
well. The reckoning is upon us.
Major bear markets follow major bull markets, often cutting stock
prices in half over a couple years or so. And these inexorable
bull-bear cycles are very unforgiving, as it can take over a decade
for stock markets to regain bull highs once a bear starts ravaging.
Gold is the refuge of choice, seeing investment demand surge as
stock markets swoon. Prudent investors deploying in gold can grow
their wealth during stock bears. |