Zeller Kern’s Investment Monitor

Is the Next Bear Market Finally Arriving?

October 23, 2018

By Steve Zeller                           

As we roll through the month of October, things are getting pretty interesting. The broad market indexes have given up half of their return for the year, and many other equity indexes are already in the red for the year. As of the market close on Friday, the Dow Jones Industrial Average closed up 4.76% year-to-date (including the reinvestment of dividends), the S&P 500 is up 5.11% year-to-date, and the NASDAQ is way off of its highs for the year and is now only up 7.90% year-to-date. However, other major indexes are now in the red for the year, including, the NYSE Composite Index – 2.74%, the Morningstar Mid Cap Core Index down -3.11%, the Morningstar Small Cap Core Index down – 3.25%, the EAFE International Equity Index down -7.58% year-to-date, and the Heng Seng Index down -14.57%. (source: morningstar.com.)

Courtesy and permission of: Hedgeye.com

But things seemed to be going so well for the markets this year, and investors seemed to be giddy about the market - How can we be spiraling down like it is? Well, things were going well for a short while as investors made certain areas of the market make their final push upward, mainly tech stocks. Earlier last summer, the NASDAQ shot up to a 17%+ return for the year. Much of the upward momentum was due to the FAANG stocks, Facebook, Amazon, Apple, Netflix, and Google. But now, many of these stocks have begun to go into a corrective pattern.

Facebook FB – Year to Date


Netflix NFLX – Year to Date       


Amazon AMZN – Year to Date


S&P 500 - Year To Date


Dow Jones Industrial Average – Year to Date


Judging by the recent volatility in the U.S. markets, investors appear to be confused. As Brad McMillan, Chief Financial Analyst of Commonwealth Financial recently pointed out, when markets are confused enough they bounce around in higher swings in either direction. Fluctuation may not be a problem within the normal course of things, and whether or not this recent activity is a pre-cursor of something bigger just ahead remains to be seen.

Although we don’t have a crystal ball, we can assess the data, and arrive at an opinion on where we are in the current bull market cycle, and where we are in the economy. From a market standpoint, we are leaning towards the opinion that we are in a peaking phase in the bull market cycle, and are considering the possibility that perhaps, we are in the beginning of a decline and possibly a bear market. As we said in recent issues of the Investment Monitor, the tech craze of today is reminiscent of the 2000 tech bubble. That being said, we are leaning towards the possibility that technology stocks are to(remove) beginning a phase of weakness and may experience a rapid decline. But this opens up opportunities for other areas of the equity market, such as utilities, consumer staples, and healthcare, and may fair better than the high beta tech stocks.

Our downside protection portfolio models shifted to a very defensive positioning about three weeks ago, raising a significant amount of cash and divesting out of equities. Our Dynamic Allocation Portfolios, which are more aggressive and historically higher returns, are beginning to move away from Tech Stocks. We also expect government intermediate bonds and long bonds to shift direction and begin to appreciate, if it becomes apparent that economic weakness is setting in.

In other words, we are leaning towards the opinion of the equity markets could begin and continue to decline, the economy to slow, and inflation to slow as well. But how can we say that, when unemployment is at an all-time low, and there are 7 million job openings and manufacturing is humming right along? We didn’t say that the economy was in a decline, but rather, it appears that it may be slowing or peaking in growth. Yes, it is true, growth has remained strong in the economy, hiring is very strong, wage growth has begun to pick up, and we have seen consumer confidence spike to an 18 year high a few weeks ago – But that is where it was at the peak of the dot com boom, too. Business confidence remains strong, government spending is pushing growth.


However, housing sales, housing starts appear to be weakening, and that is often one of the areas that begin to rollover in a slowing economy. There are also other factors that could influence the direction of the market and the direction of the economy – One being China, and another being Europe such as Italy.

China is beginning to show signs that things are not only slowing but getting ugly. The Shanghai Composite Index is down 50% from its peak in 2015, and it is down almost 30% so far this year. This is equivalent to the S&P 500 in 2000, when it was down 30%, and in 2008, when it was down 50%.

With the equity markets in China and other emerging markets, under this kind of pressure, one wonders if this is going to bleed over into the rest of the world economy. Throw in increasing trade war posturing, and things could accelerate to the downside. On the other hand, the trade war between the U.S. and China could come to a head, and some sort of agreement could happen in the future. If that were to happen, one can speculate that the market could rally, at least temporarily.

But now, we are finding ourselves in a bull market cycle that is the longest in U.S. history, and an economic cycle that has extended itself to a record length as well. Furthermore, stock market valuations are expensive, investor sentiment had reached frenzied levels of optimism, and it is against a backdrop of economic turmoil in other places in the world within a global interdependent economy. Given these conditions, it would not surprise us if we even experienced a sudden and rapid drawdown in the market, such as a 1987 style correction. By the way, here is a YouTube video that is the NBC Nightly News on October 19th, 1987, the day we experienced a 22% plus correction in one trading session.

But, that is mere speculation at this point. Nevertheless, we continue to proceed with an increased level of caution. In looking at the recent activity in the market, last week’s action in the S&P 500 caused the index to close exactly where it did the previous week at 2767.70. As this week unfolds, we will begin earning season, so depending on the reports, it may keep the market treading water. But glancing at last week’s earnings reports, we are beginning to see a very spotty output on revenues from companies. This week, the earnings report will crank up with 738 companies released with the biggest tranche of 305 on Thursday.

As we look back on the earnings reports that have already been released, so far of the 140 reports, roughly 20% of them beat their expectations. While most of the companies have beat their estimates in aggregate, they have only performed by 0.5% greater than the estimates which is well below the five-year average. The soft revenue numbers may come back to haunt the markets. Companies that have released the soft numbers have dropped on average 0.71%.

Should several of the bellwether stocks report soft earnings, this could reverse any positive effects of the reports.

Market participants will most likely begin to focus on politics which is likely to continue to drive market sentiment. While politics, earnings, and economics will all be a factor, we will likely see some further consolidation this week with markets remaining in a range.

Looking back on last week 

Looking back on last week, markets had a very mixed performance for the week as the S&P 500 finished flat but experienced a 5% loss for the month of October. So far, the Dow Jones was up 0.4%, the NASDAQ was down 0.6%, with the Russell down 0.3%Many of the major financial firms reported last week with Goldman, Morgan Stanley, Bank of America, U.S. Bancorp, Charles Schwab, and Blackrock all reporting better-than-expected profits helping to boost the financial sector by 0.8%.

The minutes from the September FOMC meeting were released on Wednesday, showing that officials generally agreed on the need for more gradual rate hikes. In addition, the minutes revealed that a number of officials saw the need to hike rates above levels expected to prevail over the long run. The probability of a December rate hike remains high, ticking up to 83.7% from 79.8% last week.

U.S. Treasuries slipped last week, pushing yields higher as the yield on the benchmark 10-yr note climbed 3 basis points to 3.20%. The U.S. Dollar Index advanced 0.6% to 95.46, but WTI crude fell 2.9% to $69.26/bbl.

With the volatility in last week’s market action, it was critical that we remained above the 200-day moving average at the 2768.24 level. The S&P closed just below this level suggesting the potential for a move down toward the 2747/2736 levels.

The configuration indicates that there should be a retest of the lows made two weeks ago at 2710.51. There are several critical levels that are likely to determine at least the next 5 to 8 sessions of market directional activity.

With the earnings to be released this week, we could see some volatility as the VPM three-day volatility indicator remains close to 40. This indicates that we are likely to see plenty of volatility as market sentiment is still uncertain keeping the daily swings larger than normal by about 1 ½ standard deviation.

Intermediate charts continue to lose momentum with PPM #1 in negative territory confirming that a minor downtrend is in place. On an intermediate basis, the key resistance is at 2855.10. As long as the market remains below this level, the S&P 500 will remain in a neutral to downtrend.

As I have discussed over the past couple of weeks, it does not appear that we are in a formation for a major decline to unfold. the configuration continues to suggest that we will remain near the 200-day/40-week, 10-month moving averages over the next 6 to 8 weeks.

All probabilities continue to point to further sideways action. However, should we close under the 2747 level, this will signal a sharp move down to test 2710.

After last week’s decline, the patterns did trigger some downward Fibonacci targets, suggesting that the S&P could decline as far as 2632, should the 2710 level be penetrated. Currently, this is only a 30% probability to occur. The 10 year treasury appears to be in position to see a surge moving toward the objective of 3.32/3.40% levels in the nearer term. If this happens, it may be one of the driving forces keeping the bears in control.

Best Wishes,

Zeller Kern Investment Committee