Have We Entered a Bear Market?
2015 was a choppy year for stocks, with the S&P 500 Index lower for the year, but able to muster a small gain once the impact of dividends was included. The high for most stock indexes was back in May, more than seven months in the past. The year was difficult for all other asset classes as well, with bonds generally lower, and commodities experiencing significant declines. In a December 31st article on CNBC, brokerage firm Societe Generale stated that according to their data, the best performing asset class in 2015 between stocks, long-term bonds, treasury bills, and commodities was stocks, which were up less than 2% on the year. It was the lowest return across those asset classes since 1938.
With continued declines during the first week of January of this year many people are asking; “Have we entered a bear market?” While we will really only know that with the benefit of hindsight, let’s take a look at some of the important data to consider at this point in time. The current bull market is the 4th longest since 1900, based upon the most recent high from May. If we were to set a new closing high for the stock market today, it would move us into the slot as the 3rd longest bull market since 1900. The fact that it has been more than seven months since we last made a new high is one reason for concern, another is that since the May high we have also experienced the largest market drop since 2011. With stocks unable to recover to a new high, it does increase the likelihood that it was the first leg down in a new bear market. If we look at the performance of other stock market indexes over the past couple of years, we see that many indexes have dropped significantly more than the S&P 500 from their recent highs.
Declines in Key Indexes from 2013-2015 highs (Through 1/7/16)1
Index Bull Market High Percent Loss
|Dow Jones Industrial Average||5/19/2015||-9.8%|
|Dow Jones Transports||12/29/2014||-24.1%|
|Dow Jones Utilities||1/29/2015||-11.4%|
|S&P MidCap 400||5/21/2015||-14.4%|
|S&P SmallCap 600||6/23/2015||-14.6%|
|S&P 500 Energy Sector||6/23/2015||-42.6%|
|MSCI World Ex USA||7/3/2014||-22.7%|
|MSCI Emerging Markets||9/3/2014||-32.9%|
Source: Leuthold Group
Looking at the state of global markets from around the world can give us some additional insight. In surveying the 46 major stock markets from around the world, we find that as of 12/31/15 that 48% of those markets have posted declines of 20% or more from their highest level over the prior year, and the median global market is down by 18.5%. This decline could be in large part due to slowing global growth and increased recession risk, which we began to see increase significantly in May, and has been weak, but has begun to stabilize in the past couple of months. While the global economic weakness has not spilled over to the United States to a significant degree, the stronger U.S. dollar has weighed heavily on manufacturing companies and we have seen persistent slowing across important manufacturing indexes for a number of months. Segments of the economy that rely on manufacturing, natural resources and exports are quite weak, but are currently being offset by a strong service sector.
If we look at the earnings growth of U.S. companies, we have seen them decline for three consecutive quarters, with the current expectation being that the earnings reported for the 4th quarter of 2015 will be down as well. If that occurs, this will be the longest stretch of negative earnings growth since 2009. Historically, when we have seen three consecutive quarters of earnings declines, there has been an above-average probability that we were entering a bear market. While this sounds quite negative, it is also important to consider that the decline in oil prices has weighed heavily on the drop in earnings, and in prior cases where the drop was heaviest in oil and we were not in a recession, cases found in 1986 and 1998, stocks continued to do well.
While we could spend a considerable amount of space covering the various indicators that argue for and against being in a bear market, let me summarize by saying that there are more factors that are negative now than there were a year or two ago.
So what should we do if it turns out that we are in the early stages of a bear market? One of the most important is to look at the economic backdrop, because market declines that occur in or around a recession are typically longer and more severe than those that do not happen around a recession. Earlier in the commentary I had mentioned that recession risk had increased outside of the United States, as we look at conditions inside of the United States, the primary recession risk factors that we look at signal below average risk for the most part. If conditions continue to deteriorate we will shift allocations away from equities and hold above-average amounts of bonds and cash and monitor and prepare to invest in the segments of areas of the market that have the greatest rebound potential once our risk measurement models indicate that we have moved back into a more positive environment for stocks.
While there appear to be more obvious headwinds going into 2016, there are also some opportunities and pockets where it is likely we will see some good strength during the coming months. We have discussed most of them in more extensive detail in prior commentaries, but it is worth revisiting some of them here briefly.
High Yield bonds – We ended the year with the yield on the H.Y. index at 8.76%, up from a yield of 6.71% at the end of 2014. This is the highest yield level since the end of 2009, and reflects the expectation that defaults are likely to increase due to the significant decline in oil prices. Bonds from energy companies typically compromise 12% – 20% of most high yield portfolios, and while it is true that defaults are likely to increase over the coming years to an expected 14% for energy companies, the typical bond recovery rate in a default is about 50 cents on the dollar, which would reduce returns by less than 1% on a typical high yield fund. We think that this will be an attractive area once oil prices stabilize and if the economy does not move toward a recession.
Preferred Stocks – This segment of the market is attractive due to above-average yields, currently above 5.8% on the primary exchange traded mutual fund that we like to use. The rebounding profitability across banks and financial service companies, which account for about 80% of the preferred stocks on the market is an important reason we like this sector. With earnings for financials expected to once again be solid in 2016, we would continue to expect it to weather the ups and downs of the markets and changing short-term interest rates better than many of the other income asset classes.
Foreign stocks – This segment has not performed very well in recent years, and in large part that is due to there being more economic weakness and political turmoil in foreign countries than here in the United States. The difference between the valuation levels for foreign markets vs. the United States is near the widest levels in 25 years. While we still currently favor domestic market over foreign markets, this will likely change when global economic growth begins to improve.
2015 was an uninspiring year for markets, and 2016 is not off to a good start. While it is possible that this could quickly turn around, as we saw in early 2014 when markets also got off to a similarly poor start, the rising number of factors supporting a bear market environment have increased and the bear should be given the benefit of the doubt until proven otherwise. We have been increasingly more defensive over the past few months with most of our investment portfolio allocations and may become significantly more defensive if our investment models receive confirmation that a bear market is in full swing. We will then remain focused on minimizing damage from a bear market and prepare to purchase segments of the financial markets that are likely to rebound the most when the bear market has run its course.
Lead Portfolio Manager
Sources & Disclosure:
- Leuthold Group
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