Almost a year ago I started warning to carry more cash in your portfolio. In September I declared that “The Bear Market Has Begun.” Finally, a few weeks ago, I explained that Markets Are Adjusting to “Slow Growth Forever.”
In the past few months we have now seen a downturn that is officially a correction and threatening to become an outright bear market. I believe that the bear market is virtually guaranteed at this point. As I covered in my annual letter, excluding the largest companies, most of the various parts of the economy reached bear market territory in 2015. Given declining earnings estimates for the third consecutive quarter, it would be a surprise if mega-caps didn’t join in the pain.
Some of the market darlings sport huge price to earnings ratios and with growth peaking even at those companies, it is unlikely they don’t fall in sympathy. After a brief relief rally, we are once again seeing the downward trends in markets. What investors need to keep in mind, is that the bear market really has begun. Short of central bank intervention – which we’ll get – there is very little hope of not completing the process. I expect the S&P 500 to reach about 1600 before reversing course upwards. It could of course get worse, but it would take a crisis event for that to happen.
The below chart takes advantage of something I learned in economics, that is, when approximating, use thick lines.
What I want to clearly show is that short of a crisis scenario, the large cap portion of the bear market has already completed a third of its likely journey. Investors need to remember that old resistance becomes new support. The previous two market peaks in 2000 and 2007 serve as the new support for the markets. The range from about 1625 to 1550 is a very strong support zone. That doesn’t mean we can’t see markets break through those levels however. A negative event that leads to other negative events could propel the S&P 500 through multiple levels of support into crisis territory.
There are any number of potential crisis that could develop that could knock the S&P 500 into the range of 1000 to 1200. The most likely more significant risk is that of a global recession without any overwhelming debt contagion. With China slowing down, this scenario is not out of the question. Due to the likelihood of more central bank interventions, on top of all the freshly click printed money already sitting around, it is highly unlikely we would see anything worse than this level of pain.
While an outright collapse is unlikely, it is not impossible. Should a major economy fall out of bed, we’d be hard pressed to avoid a contagion similar to the financial crisis. Such a collapse could start in Japan, China or Europe. By collapse, I don’t mean a typical recession. I mean outright debt and currency catastrophes similar to the 2007-09 subprime collapse. If such an event started in any of those places, it is my opinion it would quickly spread.
The reason to doubt the worst case scenario is that central banks have itchy trigger fingers. I think if we see the first level of pain broken, the central banks will load up the bazookas. I could be wrong, but history supports the bazookas. Central bankers are convinced they can print money until they can’t, and even then, they feel like they control the repercussions (I don’t think they can, but that’s for another article).
My simple message here is to be aware of the potential outcomes of what is going on right now and why it is really happening. Markets are not afraid of oil or a global recession – at least the smart money isn’t. What is happening in markets is that there is a recognition that global growth is going to average around 2% for a very long time, not 4% like pre-2007 going back to the late 1940s. This process will play out over time. While the central banks can’t bring back growth due to the demographic and debt overhangs that will last for decades, they will eventually bring about inflation to devalue debts. The result is that finding the corrective spots in the stock markets to take advantage of is extremely important to your long-term purchasing power. Don’t be scared, accept reality and prepare for it.