Last month's sell off dragged the DOW and the FTSE slightly into negative territory for the year and the bears are making a compelling case for a 20 percent market correction, which according to them has already commenced with last month's sell off. The crux of their argument is based on all three conditions simultaneously taking place, which has been remarkable in accurately predicting six bear markets within the last 40 years. The signals in question are excessive levels of bullish optimism, significant over-valuations and wide discrepancies in the performances of different market sectors. Indeed, a review of market trends since the early 1970s would indicate that no bear market has come into effect without these three conditions being fully satisfied. So when all the stars align this is the clear signal for a new bear trend, according to Hayes Martin, president of Market Extremes, an investment consulting firm in New York whose research is focused primarily on major market turning points. There have already been six times since 1970 when the market experienced irrational exuberance, dizzy evaluations and a wide variation in the performance of different market sector, according to Hayes Martin.
The first two of these three market conditions, an oversupply of bullish investors, and record overvaluations, have been evident in the markets for the last few months. For example, during December of 2013 the number of advisers who described themselves as bullish rose to above 60 percent, the latest reading on July 30 was 56 percent, nevertheless, still a reading which is in danger territory, according to a market consulting firm. Certainly, it would appear that there’s an element of contrarian investing behind this oversupply of bulls signal. In other words, to be fearful when everyone is greedy and greedy when everyone is fearful. With respect to the latter signal, excessive evaluations, this is also clearly present in the market with the price/earnings PEs ratio for the Russell 2000 index of smaller-cap stocks, after excluding negative earnings, rising in December 2013 to its highest level since the benchmark was created in 1984. The PE ratio at the end of 2013 is higher even than at the October 2007 bull-market high or the March 2000 top of the Internet bubble.
Another signal bears are getting excited over is the waning participation of traders, or lower trading volumes in the market, which has declined rapidly in the last month. One way of gauging this waning participation is by calculating the percentage of stocks trading above their average over a given time. This refers to analyzing the stocks moving average, which is a widely used indicator in technical analysis that helps smooth out price action by filtering out the “noise” from random price fluctuations. For example, the percentage of stocks trading above an average of their prices over the previous four weeks fell from 82% at the beginning of July to just 50% on the day the S&P 500 hit its all-time high. It was one of “the sharpest breakdowns in market breadth that I’ve ever seen in so short a period of time,” said Martin.
But don’t be so confident in your predictions of calling a new bear trend in the markets says Deutsche Bank chief strategist Binky Chadha. The likelihood of a selloff of at least 20 percent, which would define a bear market is unlikely, according to Chadha. Rather, what we are seeing is a secular bull market in mid-cycle. So if we see the market fall by say 10 percent, that is healthy, according to Chadha. But a correction of 20 percent doesn’t seem likely for this analyst, since three-fourths of such corrections happen near recessions and almost never occur when the trend in the unemployment rate is down, chadha concludes.
Nevertheless, there are the black swans to consider, the geopolitical situation in the Middle East, the looming sovereign debt crisis, the EU’s economic and political crisis and tit for tat sanctions over the Baltic crisis could all weigh heavily on the markets.
Whether what we are seeing is a mid cycle secular bull market or the beginning of a bear cycle is hard to gauge, particularly when we analyze the fundamentals and throw into the equation the unknown variables, there are too many in this market. Maybe technical analysis might be a better tool in trying to see through the muddy water, after all the signals are clearer.
