Zeller Kern’s Investment Monitor

From a Bull Market Top to the Beginning Stages of a Bear Market?

December 12, 2018

By Steve Zeller                           

The bull market, as we were suggesting back in October, may be in the process of morphing into a “bear market” that could extend into and through the end of the first quarter of 2019. The U.S. equity markets are in the red for the year now, with many indexes beginning to ring up some notable losses. Contrary to what many observers believe, and what we have been suggesting, the economy is showing signs of slowing down, with the risk of a recession possibly taking hold towards the end of next year. Although fourth quarter GDP will come in with a positive number, it will likely be a weaker growth rate and below the latest estimates.

Even though we may experience a rebound within the next few days or weeks, the market is at risk to continue its downward trend, in our opinion. The market phase we entered into, has been crushing Tech stocks and may continue to do so. Utility stocks and Consumer Staples, as we mentioned in the prior issue, are sectors that will more likely experience gains or at least hold their ground. Government bonds will likely have a strong showing too. Contrary to the earlier consensus of investors fearing accelerating inflation and rising bond yields, we will more likely experience the opposite, with government bonds continuing to rally and inflation decelerating with the possibility of deflation, if not here in the U.S., then certainly abroad. Popular belief earlier this summer was for the yield on the 10 year treasury to hit 4%. It went as high as 3.23% and now has dropped to 2.85%.The dollar should continue to be strong.

As of the market close on last Friday, The Dow Jones Industrial Average (including the reinvestment of dividends) barely remains in positive territory, up just .90%. The S&P500 Index is barely up, just .32% year-to-date, counting dividends. However, The Russell 2000 small cap index is down -4.60% year-to-date, the NYSE Composite is down -6.77% year-to-date. Other indexes are faring poorly such as U.S. Basic Materials Index down -16.32%, U.S. Financial Services Index down -5.58%, and U.S. Industrials Index down -7.44% (source: Morningstar.com).

The MSCI International Index is down – 11.44% (including the reinvestment of dividends), and the MSCI Emerging Markets Index is down -15.29% year-to-date. Many major bond indexes remain in negative performance territory for the year, but government bond indexes have rallied in the last 4 weeks, with the Morningstar U.S. Long Government Bond Index, though being down -2.78% year-to-date, has rallied 4.51% in the last four weeks, with much of it occurring within the last week.

As we have noted many times before, markets off of their highs, fall faster than they climb and wipe out many months and sometimes years of gains in short order. It is part of our investment philosophy to avoid these kinds of events. The art of having wealth is not making it, but rather keeping it, in our view. Yes, growing wealth is important, but not losing wealth is twice as important.

As investors pursued their flight to risk, loading up on the FAANG stocks, Facebook, Apple, Amazon, Netflix, and Google, are now feeling the wrath of a severe correction and potential bear market at hand. As we mentioned towards the beginning of the year, the frenzy of investors and their love affair with these stocks was very reminiscent of the 1999-2000 time period, which ended up being a disaster for those investors. So here we are with the “Zombie Bulls” on the march, with this downturn being dusted off as a typical “buying opportunity”. The only problem is that in the current market phase, stocks could continue to experience lower lows and lower highs, as the march downward continues. As Elliott Wave International pointed out a headline posted on CNBC back on October 11th, “Massive Pullback in Tech Stocks Is a Buying Opportunity: We Love Seeing the Panic”. Given all of the data we follow, we beg to differ and are becoming convinced that these pull backs may be the beginning of larger decline, which we will stick with until we see the data tell us otherwise.

S&P 500 Index – Year-to-Date

Dow Jones Industrial Average – Year-to-date

The Party looks to be over for Apple – 5 year chart               

And Then There’s Facebook – 2 Year Chart

Remember, all things considered, the market has been overdue for a bear market. The bull market, if completed, will have lasted almost 10 years, which is one of the longest on record. Add in a market with expensive valuations, a peaking of earnings for the tech sector that took place in the second quarter of this year, record stock buybacks, record corporate debt levels, historically high margin debt levels, historically high levels of investor optimism, the prospect of a recession, and you have all of the ingredients for a market top and an oncoming extended bear market.

But opinions aside, it is hard to argue with the data. All of the vital data points we follow indicate both growth and inflation slowing which is concerning for risky assets such as tech stocks, energy stocks, industrial stocks, and lower quality credit or junk bonds. The rate of change for growth and inflation is what matters most, and both of them are slowing. Take a tour around the world and see that many countries and regions are in bad shape and getting worse, in addition to commodities and oil which have been declining too. Oil is down 31% since October, and the CRB Commodities Index continues to decline. Both of those indexes represent an outlook for inflation, and both of them are reflecting a slowing of inflation.

Recession Alert Weekly Leading Economic Index–appears to be in decline

The Recession Alert Weekly Leading Economic Index, provided by dshort.com, is clearly in a slowing mode – not a stagnate mode nor a strengthening mode. As you can see from the chart above, the index has previously headed down to the brink of recessions but then bounced off and headed back up. We’ll see what happens. But, along with all of the other vital data points that point to a slowdown, global stock markets continuing to struggle, and now the political unrest in Europe, we are comfortable defending our defensive position as we have been since the beginning of October. For those of our readers that may recall, we were very bullish at the end of 2016 all through 2017, but pointed out that we expected that there was a significant chance that this party would end in 2018 or early 2019. So far, this looks to be the case.

If you are not a client, and would like input from us on how best to protect your portfolios moving forward into 2019, please feel free to connect with us.

Looking back on last week
The S&P 500 declined 4.6%, as global growth concerns were exacerbated by negative developments regarding U.S-China trade negotiations and the continued flattening of the U.S. Treasury yield curve. The Dow Jones Industrial Average lost 4.5%, the Nasdaq Composite lost 4.9%, and the Russell 2000 lost 5.6%.

Economic growth concerns were cast into the spotlight by a decisive curve-flattening trade in the Treasury market that featured some inversions on the short end. The 2-yr yield (2.70%) and 3-yr yield (2.71%) closed higher than the yield on the 5-yr Treasury note (2.69%) this week.

Also, the difference between the 2-yr and 10-yr yields narrowed to its slimmest margin since 2007. Specifically, the 2-yr yield lost 11 basis points to 2.70%, and the 10-yr yield lost 16 basis points to 2.85%.

In a broader context, concerns over future economic growth drove market participant’s concerns. This has fueled most of last week's selling, which completely unwound the 4.9% gain for the S&P 500 from the prior week. 
The worst-performing sectors this week were the financials (-7.1%), industrials (-6.3%), materials (-5.2%), information technology (-5.1%), and health care (-4.6%) sectors. The only two sectors that escaped the week with a gain were the utilities (+1.3%) and real estate (+0.3%) sectors.

The energy sector (-3.1%) was down for the week, yet it outperformed the broader market, helped by a 3.1% bump in oil prices to $52.52 per barrel.

The November Employment Report on Friday helped substantiate the view that the need for aggressively raising rates in 2019 will not be likely. The nonfarm payrolls were weaker than expected at 155,000 and average hourly earnings increasing 0.2%, indicating that the wage growth acceleration the Federal Reserve has been bracing for is not occurring.

The last two sessions of last week exhibited extreme volatility as Friday’s action completely reversed Thursday’s rally, closing below the 21-month moving average at 2645.91 with a close at 2633.08.

This is significant as it signals a retest of the lows made in November at the 2603.54 level. A close below this level today will signal a move toward the 2567/2502 levels with the extreme at the 2469 level. 

The intermediate trends have confirmed major downtrends and indicate 8 to 12 weeks of downward movement, confirming the targets discussed above. The major resistance points above the market is at the 2711 level. There is now only a 30 percent probability for the S&P 500 to move above this level. 

The long term monthly chart also confirms that the beginnings of a multi-year bear market is forming. With PPM 1 monthly at a -.38 with the 10-month moving average at 2748.93 representing major resistance. 

This week is a critical week and a close on Friday below 2603 will confirm a nasty end to what will be a terrible year for the markets.

Best Wishes,

Zeller Kern Investment Committee