Stock markets are forever cyclical, an endless series of alternating bulls and bears. And after one of the greatest bulls in U.S. history, odds are a young bear is now gathering steam. It is being fueled by record Fed tightening, bubble valuations, trade wars, and mounting political turmoil. Bears are dangerous events driving catastrophic losses for buy-and-hold investors. Different strategies are necessary to thrive in them.
This major inflection shift from exceptional secular bull to likely young bear is new. By late September, the flagship US S&P 500 broad-market stock index (SPX) had soared 333.2% higher over 9.54 years in a mighty bull. That ranked as the 2nd-largest and 1st-longest in U.S. stock-market history! At those recent all-time record highs, investors were ecstatic. They euphorically assumed that bull run would persist for years.
We humans naturally extrapolate present conditions lasting way out into the indefinite future. But long centuries of stock-market history have painfully proven that no bull lasts forever. Eventually they all lead to inherently-unsustainable fundamental, technical, and sentimental excesses. These can only be bled away and ultimately normalized by bear markets. So bull markets have always been followed by bears.
Bulls and bears are easily defined technically, 20%+ SPX moves uninterrupted by opposing 20%+ moves. The greatest stock bull in US history was the SPX’s 417.0% run over 9.46 years between October 1990 to March 2000. That climaxed in the tech-stock bubble, when wild optimism about stock-market fortunes reigned. Yet that soon gave way to tears as the subsequent bear mauled the SPX 49.1% lower in 2.6 years!
Stock investors suffering their wealth getting cut in half is typical in major bears. But the losses extend well beyond capital into far-more-scarce time. After that turn-of-the-century secular-bull peak, the SPX wouldn’t power decisively above those levels again until 12.9 years later in early 2013! That’s nearly a third of the 40 years average investors have between the ages of 25 to 65 to generate wealth to finance retirement.
If you can’t afford to lose half your stock-market wealth, and you don’t have time to wait for well over a decade for stock prices to fully recover, you better take this quarter’s market developments very seriously. Something snapped in the U.S. stock markets in early Q4’18, and the price action and volatility since reeks of a young new bear. While that diagnosis can’t be certain until the SPX falls 20%+, the signs are ominous.
As Q4’18 dawned, the U.S. Federal Reserve ramped its quantitative-tightening campaign to full speed. QT is necessary to start unwinding 6.7 years of quantitative easing ending in October 2014, during which the Fed conjured $3625b out of thin air to monetize bonds! QE was considered necessary to stimulate the economy after the Fed forced interest rates to zero in December 2008 during the first stock panic in a century.
Those trillions of dollars of QE capital injected by the Fed directly levitated the stock markets, artificially inflating an already-mature bull market to monstrous proportions. All those bonds accumulated on the Fed’s balance sheet, which skyrocketed 427% higher over that relatively-short QE span! The Fed can’t maintain $3.6t of bonds on its books forever, so it finally started letting them gradually roll off at maturity in Q4’17.
That unprecedented QT capital destruction started small, but was ratcheted up each quarter until Q4’18 when it reached its terminal velocity of $50b per month. The SPX achieved its latest all-time record high in late September, and then October was the first month ever of full-speed QT. The QE-levitated stock markets wilted under this QT onslaught, which was inevitable sooner or later. I warned about all this in advance.
Just a week after the SPX peaked in late September, I published one of my most-important essays ever. I unambiguously titled it “Fed QT is Bull’s Death Knell”, and it explained the stock-market impact of Fed QE in depth and why full-speed QT was certain to slay this bull. With the SPX just 0.6% under its recent record high on that final day of Q3’18, that warning fell on deaf ears. Maybe investors will pay attention now.
Fed QT is no flash in the pan, it is a long-term persistent threat to these lofty stock markets. In order to merely unwind half of that unfathomable $3.6t of Fed QE, full-speed QT at $50b per month will have to run for 30 months starting in Q4’18. Heading into 2019 the stock markets face another 27 months of this! And the Fed is loath to slow or stop its QT now underway on autopilot, as that could unleash panic-grade selling.
The Fed has long asserted the reason it is undertaking QT and has hiked rates 9 times since December 2015 is the US economy is strong. It wants to rebuild easing-ammunition stores to use in the inevitable coming recession. If the Fed caves on QT before its balance sheet shrinks much lower, traders will assume the Fed fears the US economy is in serious trouble. So they would flee stocks pummeling them far lower.
The die is cast on Fed QT, guaranteeing the long-overdue next stock bear. And the losses seen so far are just a small vanguard of what’s to come. This first chart superimposes the mighty SPX bull of the past decade on its so-called fear gauge, the VIX S&P 500 implied-volatility index. The recent Q4 trading action in both is unlike anything yet seen in this entire bull. It is looking far-more bear-market-like in character.
Major stock-market selloffs are defined based on size. Anything under 4% isn’t worth classifying, it is just normal market noise. Then from 4% to 10%, selloffs become pullbacks. In the 10%-to-20% range they grow into corrections. And of course beyond that at 20%+ they are in formal bear-market territory. This selloff snowballed darned close to beardom on Christmas Eve, the SPX plunging to a 19.8% loss over 3.1 months!
Just 4 trading days earlier before the latest FOMC decision, it was only down 13.1%. While that latest Fed rate hike was expected, the future-rate-hike outlook among top Fed officials wasn’t dovish enough for stock traders. Despite all the market carnage since the previous dot plot, their effective forecast for future rate hikes was merely lowered from 4 more to 3. So the SPX plunged 7.7% over the next 4 trading days!
Even before that this selloff hasn’t behaved like a normal bull-market correction. Their purpose is to vent excessively-bullish sentiment, rapidly bleeding off greed. Sharp selloffs are necessary to do that. Traders don’t get worried until stocks fall fast enough and far enough to shatter their complacency. So normal bull-market corrections are usually front-loaded with sharp selloffs that trigger soaring levels of fear.
Prevailing fear levels are inferred by the VIX, which technically measures the implied volatility in 1-month SPX options. Before last peaking in late September, the SPX suffered 5 bull-market corrections within its epic secular bull. Heading into July 2010 the SPX fell 16.0% in 2.3 months. That spawned some real fear, as evident in the VIX soaring to a 45.8 peak. The effective fear ceiling outside of panics and crashes is a 50 VIX.
The next SPX correction cascaded 19.4% lower over 5.2 months ending in October 2011. Despite its long span, the VIX skyrocketed as high as 47.5 in its midst. That was real fear, the kind necessary to slay exuberant greed and rebalance sentiment to keep an ongoing stock bull healthy. After that the SPX went a near-record 3.6 years without a single correction-grade selloff in an extraordinary levitation driven by the Fed.
That’s when its unique open-ended third quantitative-easing campaign was in full swing. QE3’s peak year was 2013 which saw the Fed monetize a staggering $1020b of bonds! The SPX soared 29.6% higher that year on such vast liquidity injections. But 2014 saw QE bond buying collapse to $450b as the Fed tapered QE3. The SPX only rallied 11.4% that year, its gains shrinking 62% in proportion with QE3’s 56% decline.
The QE3-goosed stock markets wouldn’t correct again until well after QE3 ended, the SPX sliding 12.4% over 3.2 months into August 2015. Again the VIX surged to 40.1, which is up in the very-high fear zone. The next debatable correction followed right after. The SPX didn’t achieve new highs after the previous one, so it was technically one compound correction instead of two separate ones. Analysts render it both ways.
That second correction or second part of the longer one saw the SPX fall 13.3% over 3.3 months into February 2016. That was the only bull-market exception that didn’t see a high VIX, it merely climbed to 28.1 at best. But since the VIX had just recently surged over 40 in a fear climax, another one apparently wasn’t necessary. That rolling-over SPX action into early 2016 actually looked more bear-like than bull-like.
Provocatively it took fully 13.7 months after that May 2015 topping for the SPX to finally hit new highs confirming its bull was alive. The thing that short-circuited what felt like a young bear was hopes for more European Central Bank easing after the UK’s surprise Brexit vote in late June 2016. Then the SPX again exploded higher in November 2016 after Trump’s surprise presidential victory with Republicans controlling Congress.
Optimism and greed exploded on hopes for big tax cuts soon, fueling a powerful stock-market surge into early 2018. The SPX then corrected sharply into early February with a 10.2% plunge in just 0.4 months. The VIX shot up to 38.8 on that, showing real fear. All bull-market corrections with the lone exception of the second part of that compound one exhibited telltale fear spikes averaging VIX peaks way up at 43.1.
But the recent SPX selloff of Q4’18 coinciding with the first-ever full-speed Fed QT looks way different. It has been mostly an orderly, gradual selloff generating modest fear. The highest VIX close between late September and pre-FOMC in mid-December was merely 25.8! Even on Christmas Eve it only hit 35.8. These are too low for normal sharp bull-market corrections, this fear profile is looking more like a bear downleg.
While bull-market corrections are supposed to shock and scare, bear-market downlegs start more subtlety. Instead of plunging fast then stabilizing, bear selloffs start slow then gather steam later. Bears begin in stealth mode, only gradually rolling over to prevent fear from spiking. Without big fear to wake them up and scare them out, investors complacently stay deployed as their losses slowly and inexorably mount.
Like the proverbial frog slowly being boiled alive, investors don’t realize the peril their capital is in during bear markets until way too late. The lack of normal bull-market-correction fear spike during this latest correction-grade selloff disturbingly suggests a new bear has awoken. And coming after such a massive and largely-artificial QE-inflated stock bull, the fearsome bear QT has to spawn should be proportionally large.
On Christmas Eve the SPX was forced close to a 20% bear-cub loss at 2345. That level was first seen in February 2017, and represents nearly 3/4ths of the post-Trump-election taxphoria rally being wiped out. 30% would drag the SPX back down to 2052, which were November 2014 levels right after the QE3 bond monetizations ended. 40% would crush the SPX to 1758, back to October 2013 levels killing 4.9 years of gains.
But after one of the biggest and longest stock bulls in U.S. history, it would be shocking if the subsequent bear didn’t lop off at least 50%. Especially given this bull’s artificial QE-inflated nature in an era where QE-conjured capital is being destroyed by QT. A 50% SPX loss from late-September’s peak would leave it at 1465. Those levels were first seen in this bull all the way back in September 2012, 6.0 years earlier.
While a 50%+ bear warning may sound sensational or overly dramatic, it’s actually fairly conservative. The SPX already suffered two bear markets since the tech-stock bubble peaked in March 2000. The first one ending in October 2002 mauled the SPX 49.1% lower over 2.6 years. The second one climaxing in the first stock panic in a century drove a far-worse 56.8% SPX decline in just 1.4 years ending in March 2009.
50% bears are totally normal after large bulls, even when they don’t have the amplifying dynamics of the first-ever colossal-scale Fed QE and QT. This overdue next bear has a great chance of growing bigger than normal after such a monstrously-grotesque bull. Most investors won’t figure this out until too late. Unlike bull-market corrections, high-fear VIX spikes soaring into the 40-to-50 range don’t ignite until later in bears.
While the extreme Fed tightening under this unprecedented full-speed QT campaign could easily drive a major stock bear alone, so could excessive valuations. When the SPX peaked in late September, its 500 elite stocks were collectively trading at literal bubble valuations! Extreme valuations are what usually cause stock bears, which exist to force stock prices back into line with corporations’ underlying earnings.
The classic honest way to measure valuations is through trailing-twelve-month price-to-earnings ratios. These take companies’ last four quarters of actual hard GAAP earnings, add them up, and divide them by companies’ prevailing stock prices. Unlike fictional forward earnings, real past results aren’t mere guesses about the future. Over the past century and a quarter or so, the U.S. stock markets averaged a 14x TTM P/E.
That’s long-term historical fair value, which is logical and reasonable. The reciprocal yield of 14x is 7.1%, an interest rate that is mutually beneficial to both pay and be paid for investment capital. Twice that at 28x earnings is the formal bubble threshold. As of the end of September just after the SPX peaked, its elite companies averaged a TTM P/E well into bubble territory at 31.4x earnings. They were dangerously overvalued.
This next chart looks at average SPX valuations in TTM P/E terms over the past couple decades or so. The 500 SPX components’ simple-average P/E is rendered in light blue. The dark-blue line shows it instead weighted by companies’ market capitalizations. The SPX is superimposed over the top in red, while a hypothetical fair-value SPX at 14x earnings is shown in white. This valuation picture is ominously damning.
The bubble valuations around the SPX’s late-September peak were nothing new. They had been above that 28x threshold continuously for 14 months since July 2017. Stocks were already expensive before Republicans swept the November 2016 elections kindling those exuberant big-tax-cuts-soon hopes. But they got a lot more expensive after that as stock prices soared way faster than corporate earnings since.
Again excessive valuations are what normally spawn stock bears. Stock prices get bid up too fast during bull markets for underlying earnings to justify. So bears follow bulls to drag stocks lower or just sideways for long enough for corporate profits to catch up with prevailing stock prices. These mean reversions after large bulls usually see valuations overshoot towards the opposite extreme before bears give up their ghosts.
So odds are this young stock bear won’t head back into hibernation until the stock markets’ average TTM P/E ratio per the elite SPX components actually falls under 14x. Major bears usually bottom with the SPX P/E in the 7x-to-10x earnings range, the former being half fair value when stocks are very cheap and screaming buys. Late in the last stock bear climaxing in March 2009, the SPX’s TTM P/E slumped to 12.6x.
But let’s be conservative and just assume this next bear, even with Fed QT, merely mauls stocks long enough to force a fair-value 14x P/E with no overshoot. Assuming corporate earnings don’t grow much which is a real possibility during a serious stock bear, that implies 51% downside from the SPX’s late-November levels. That was the latest month-end valuation data available when this essay was published.
Historical fair value sans earnings growth implies a bear-market bottom near SPX 1356, or 53.7% under late September’s peak! That’s right in line with historical major bear markets, nothing unusual. As bears generally last a couple years or so, modest underlying corporate-profits growth could lift that valuation-based bottoming target maybe 10% or so. That still implies a 49.1% total bear which isn’t to be trifled with.
The combination of wildly-unprecedented full-speed Fed QT slamming QE-inflated stock markets trading at bubble valuations is incredibly menacing. Seeing bear-market-like rolling-over selling behavior without big fear spikes in recent months strongly argues the overdue bear has awoken. But since all that selling has been concentrated fully within a single quarter, odds are most investors don’t realize how bad things are.
The biggest group of investors with the most capital are casual retirement investors who don’t closely follow the markets. They avoid much work and stress by paying other people to manage their money. These investors get statements showing their portfolios’ fortunes after every calendar quarter. At the end of Q3’18, everything still looked awesome with the SPX just 0.6% under its all-time high of a week earlier.
So the Q4’18 statements due out in January could prove shocking, spawning fear and galvanizing bearish psychology. The most-widely-held stocks in investment funds are the biggest and best ones led by the market-darling mega techs. While they were radically overvalued at the end of Q3, no one cared at that point. Everyone owned the largest US stocks including Apple, Amazon, Microsoft, Alphabet, and Facebook.
Add in the last FANG Netflix, and these 6 stocks alone commanded over 1/6th of the entire market cap of the SPX just before the Q4 selling started! Their average TTM P/E was a scary 80.2x earnings, 2.6x the entire SPX’s. Yet these beloved companies were believed to have such amazing businesses that they should be immune to economic slowdowns or stock-market selloffs. That myth was obliterated in Q4.
This SPX selloff first hit 10%+ correction territory on Black Friday with a 10.2% loss from its peak. On that same day, mighty Apple, Amazon, Microsoft, Alphabet, Facebook, and Netflix had collapsed 25.8%, 26.4%, 10.8%, 19.9%, 39.4%, and 38.2% from their recent all-time highs! They averaged 26.8% losses, or 2.6x the SPX’s. Many if not most investors’ Q4’18 portfolio results are going to look even worse than the SPX.
Will they start fleeing and adding to the selling pressure when these gaping holes in their precious capital are revealed? And while record Fed tightening and a mean reversion lower out of bubble valuations are the primary bear-market risks, they aren’t the only ones. The trade wars between the US and China and other countries are intensifying, and U.S. political turmoil will soar next year with Democrats controlling the House.
The epic corporate stock buybacks that helped levitate the stock markets in recent years will wane as the Fed forces interest rates higher. Trillions of dollars of these buybacks were debt-financed over the past decade. And as stock markets fall, Americans will feel poorer and spend less. This negative wealth effect will really weigh on record corporate profits, potentially driving them lower forcing valuations even higher.
The Fed’s QT isn’t the only howling central-bank headwind stock markets face. The European Central Bank is also halting its own massive QE bond monetizations starting in January! That will suck even more capital out of the system. Many of these bearish factors for stocks feed on each other too, with all combined wreaking more havoc on sentiment and stock prices than individual ones ever could in isolation.
Investors really need to lighten up on their stock-heavy portfolios, or put stop losses in place, to protect themselves from this young bear market. It’s only just beginning, with sub-20% SPX losses at worst a far cry from 50%+. Cash is king in bear markets, since its buying power grows. Investors who hold cash during a 50% bear market can double their stock holdings at the bottom by buying back their stocks at half-price.
Put options on the leading SPY S&P 500 ETF which perfectly mirrors the SPX can also be used to hedge downside risks. But options trading is risky, with 100% losses possible if the timing doesn’t work out. And cash doesn’t appreciate in value. So the best bear-market investment is gold, which tends to rally on surging investment demand as stock markets weaken. Gold investment grows wealth during stock bears.
Gold surged 30% higher in essentially the first half of 2016 in a new bull initially sparked by those late-2015 and early-2016 SPX corrections. Investors fled burning stocks and flocked to gold. And the gold miners’ stocks really leveraged those gains, rocketing 151% higher in that same timeframe. The gold stocks are not only wildly undervalued, but just breaking out technically which should accelerate their upside.
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The bottom line is a young stock bear sure looks to be awakening. Q4’s rolling-over stock-market selling without big fear spikes is ominously classic bear-market behavior. And after such a monster bull, the next bear is long overdue. Unprecedented full-speed Fed QT colliding with bubble-valued U.S. stock markets artificially inflated by long years and trillions of dollars of Fed QE can’t end well. The reckoning is upon us.
Major bear markets follow major bull markets, often cutting stock prices in half over a couple years or so. And these inexorable bull-bear cycles are very unforgiving, as it can take over a decade for stock markets to regain bull highs once a bear starts ravaging. Gold is the refuge of choice, seeing investment demand surge as stock markets swoon. Prudent investors deploying in gold can grow their wealth during stock bears.
Adam Hamilton, CPA
December 31, 2018
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