Is a Severe Bear Market in the Offing?

Market corrections happen every year. The absence of a greater than 10% decline in broad markets in 2013 and 2014 was more of a historical aberration rather than the norm. To many investors this lack of any significant respites in the steady climb upward proved to be particularly challenging, as they had clamored for the opportunity to put more money to work in this multi-year bull market. But now we may be in the midst of that opportunity. Since August 18, the S&P 500 Index has experienced wide swings – staging at one point a 11.1% decline from its peak during that period – and may potentially be retesting the August lows this week.

Unfortunately, rather than seeking out the many attractive stocks which may be available at a discount, many investors are heading towards the exits. In fact, since April, equity mutual funds have experienced $33 billion in outflows, with half of that coming in the last six weeks alone.1

Market corrections tend to culminate at extreme levels of panic and volatility:

• Intraday volatility has reached levels last experienced during the lows of 2008 and before then, in 1987.
• The CBOE Volatility Index (VIX) has reached levels last touched during the 2011 market correction that came in response to the European sovereign debt crisis and U.S. debt ceiling.
• Market sentiment has deteriorated. According to a poll by Investors Intelligence, the percentage of all advisors that are bullish has fallen below 30%, a level not seen since the height of the 2008 financial crisis.

None of us mere mortals can accurately call the bottom of any market correction. What we can do is identify whether the conditions for a severe bear market are evident.

• Traditional bear markets typically require a substantial amount of leverage in the system so that selling begets margin calls and additional selling, and the whole thing spirals downward. Today, leverage is not a significant issue.
• End of cycles and severe bear markets are usually associated with monetary policy tightening cycles and flattening or inverting yield curves. Today, the U.S. Federal Reserve, in a world awash with disinflationary forces, is erring on the side of caution, while most central banks around the world are easing policy.
• Severe bear markets are typically associated with significant deterioration in growth around the world. Today, global economic growth, while not robust and certainly not synchronous, is expanding at a modest clip.

That may be all well and good, but isn’t China poised to bring down the global economy? We’ve heard time and again that the catalyst for the recent market correction was the severe slowdown in Chinese economic activity and the looming disruptions for the global economy at large. I dispute that assertion wholeheartedly. Chinese industrial production has been in a recession for four years now. The fact that the market decided to begin worrying about it in August 2015 does not make it a new phenomenon. It should be no surprise to anyone that Chinese growth would slow as the country de-levered from a massive property market bubble, and slowly evolved from an investment- and export-based economy to a more consumer-based one.

The more surprising fact, as this transformation continues, is that the leading economic indicators of more than half of the countries on Earth are currently in expansionary territory. This includes the United States, many countries in Europe (Italy, Spain, Ireland and Germany, for example), and non-commodity- producing countries of the emerging markets like India, as well as those that stand to benefit from improving economic activity in the United States, like Mexico.

So can the global economy withstand a marked slowdown in Chinese growth? It already has.

For markets, it has always been about the Fed. The recent bout of volatility was based on concerns that the Fed had already tightened policy in the aftermath of Quantitative Easing, and was poised to tighten further with the first rate hike since 2006. The uncertainty around future Fed action will last until the end of this year and into the beginning of next year and volatility may persist. Ultimately, modest growth and benign inflation will take the Fed out of the equation.

For all these reasons, we believe the great bull market that began on March 9, 2009 will endure, albeit with more modest results for investors.

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