Is a Bear Market in Place Now? China’s Impact and Influence Reviewed

by the Curmudgeon with Victor Sperandeo

Introduction:

A Bear is on this week's Barron's cover with a “Bear Scare” notation. But is it just a “Bear Scare” or the real thing? We really don't know if a bear market is underway until the popular stock market averages have registered (at least) a 20% of decline from this year’s bull market high. We could then conclude that a bear market started the day after the 2015 high(s) were made in each average.

In my opinion, the bear will be in control if the August 2015 lows are taken out. If that's the case, then we can safely say we're in the second down leg of a bear market that will likely last for years due to stock market overvaluation (see Victor's comments in last week's Curmudgeon post) and excesses that have built up from years of central bank ultra-easy monetary policies.

Take Forecasts with a Grain of Salt:

The reader should not place faith in any financial market forecasts. Not even mine. Why? Because they're almost always wrong!

A Bespoke report, noted in the January 10, 2016 NY Times, reviewed the recent history of Wall Street predictions and found them very inaccurate. Since 2000, it found, the consensus has called for an average yearly increase in the S&P 500 of about 9.5%. The actual average annual change was less than 4%, while consensus predictions were inaccurate in every single year - sometimes by outrageous margins. In 2001, the consensus called for a gain of 20.7%. But the index fell by 13%. In the horrible year of 2008, the consensus was that the market would rise 11.1%. As many investors may recall, it fell by 38.5%. Not once since 2000 has Wall Street predicted that the market would decline in a calendar year. Yet the market actually fell in five of those years.

Expert Opinion - Leuthold Weeden's Doug Ramsey:

From the January 8, 2016 Green Book: Not A “Stealth” Decline Any Longer...:

We’re assuming the decline that’s kicked off the new year is the second down-leg of a cyclical bear market that dates back to the S&P 500’s record closing high on May 21, 2015. Ironically, the most compelling evidence that a bear market is underway may not be what’s been punished (Transportation stocks, Small Caps), but what hasn’t. The accompanying table shows the enormous performance gap between the S&P High Beta Index (down almost 25% through January 7th) and its counterpart Low Volatility Index (which is off a mere –4.9% from a high made less than two weeks ago, December 29, 2015). Consumer Staples reached a new all-time high on the same day, and we suspect those highs will be the last bull market highs recorded by any composite or sector index. The irony is that the highs in these supposed safe havens were made exactly one year after the bull market peak in the Dow Jones Transports, which ultimately became the bear’s first victim. We expect more victims ahead, including (eventually) the “safe haven” stocks.

Importance of China to World Economy and Global Equities:

Our last two Curmudgeon posts highlighted why China was the key to world economies and global equities in 2016. You can review them here and here.

Many experts say this past week's global stock market route was almost entirely due to China's inept policy on circuit breakers and attempts to stabilize their stock market.

"I just think there's an underlying nervousness that we're going to see further turbulence out of China," said David Lefkowitz, senior equity strategist at UBS Wealth Management Americas. Performance in U.S. stocks depends "on willingness to believe the expansion is intact and the U.S. is going to remain relatively unaffected."

On that same theme, Andrew Browne wrote in the January 9, 2016 WSJ (on-line subscription required):

Investors have a right to feel concerned about the mishandling of the markets, given the magnitude of China’s long-term economic problems and the knowledge that when it comes to fixing them nothing short of flawless execution will do. All the big drivers of growth are running out of steam at the same time, including what had seemed an endless stream of rural labor and insatiable overseas demand for Chinese manufactures. China must upgrade its entire manufacturing sector while grappling with the legacy problems of the old growth model, including a despoiled environment and massive debt.

Instead, we’ve seen almost comical ineptitude, the most recent example being the introduction of circuit breakers to reduce volatility in the stock market.

The measure had been fast-tracked by the securities regulator after the stock-market wobbles made Mr. Xi look more vulnerable than at any time since coming to power in 2012. But the circuit breakers had to be abandoned after only four days—because they made volatility much worse.

“It’s Amateur Hour!” writes the Shanghai-based economist Jonathan Anderson of the Emerging Advisors Group.

The irony is that the real economy is actually looking up a bit after appearing to go into free fall earlier last year. Crucially, the residential real-estate market is rebounding.

Investors seem to be spooked more by policy muddles than economic data. Some suspect that policy makers must have lost their once-steady touch because they’ve been so rattled by problems only they can see.

In a January 11, 2016 FT column (on-line subscription required), former U.S. Treasury Secretary and Harvard President wrote:

Over the past year, about 20% of China’s growth as reported in its official statistics has come from its financial services sector, which is now about as large relative to gross domestic product as in Britain, and Chinese debt levels are extraordinarily high. This is hardly a case of healthy or sustainable growth. In recent years, China’s growth has come heavily from massive infrastructure investment; China poured more cement and concrete between 2011 and 2013 than the US did in the whole of the 20th century. This too is unsustainable. Even if it is replaced by domestic services, China’s contribution to demand for global commodities will fall.

Experience suggests that the best indicator of a country’s future economic prospects is the decisions its citizens make about keeping capital at home or exporting it abroad. The renminbi is under pressure because Chinese citizens are eager to move their money overseas. Were it not for the substantial recent depletion of China’s reserves, the renminbi would have fallen further. (one paragraph skipped)

Because of China’s scale, its potential volatility and the limited room for conventional monetary maneuvers, the global risk to domestic economic performance in the US, Europe and many emerging markets is as great as any time I can remember. Policymakers should hope for the best and plan for the worst.

The Difficulty of Short Selling- Even in a Bear Market:

Even if we are in a full-fledged bear market, it has and will be very difficult to make money on the short side. That's largely because of violent, counter trend rallies that will shake out the shorts. We attribute that to the dominance of computerized, algorithmic and high frequency trading. Then there's the matter of surreptitious buying of stock index futures and/or ETFs by the Fed or its surrogates. We've called attention to that tactic by providing anecdotal evidence in many previous Curmudgeon posts.

Here's what Victor has to say about that now:

Last week, The S&P 500 and Dow Industrials posted their worst 5-day start to a year on record. The S&P 500 dropped ~6% on the week. But that was nothing like a 10% decline in a single day, as happened in China last week.

The Fed and global central banks (especially the ECB and BoJ) have done anything and everything to keep the markets up. As Mario Draghi put it "we'll do whatever it takes!" Indeed, central banks, virtually all over the world have been telling the financial markets by their actions that they wanted higher markets. This has made selling short a losing trading strategy.

However, with QE ended, and interest rates rising, I believe this has now changed. The Fed seems willing to allow the equity markets to decline in a steady, but “reasonable” fashion.

Curmudgeon: Perhaps, that's because of the recently stronger than expected employment reports? Therefore, the saying: "Never fight the Fed" is temporarily not in play as the sentiment of the day. The Fed is out to lunch for now.

Bottom line: It's time to consider shorting if you are a trader.

Good luck and till next time...

The Curmudgeon
ajwdct@sbumail.com

Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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