BERLIN – A perfect storm of a decelerating Chinese economy, an accelerating drop in petroleum prices, tightening Federal Reserve policy, and a strengthening U.S. dollar led to the worst start to a year for U.S. equities on record in 2016.
The S&P 500, the Dow Jones Industrial Average, and the NASDAQ Composite were down 8.95 percent, 9.41 percent and 10.67 percent respectively, year-to-date, through January 20, before modestly recovering. With some indicators approaching bear market levels, we examine bear market dynamics in this Weekly Letter. The average stock in the S&P 500 is already 25 percent below its 52-week high.
Furthermore, both the equally weight-ed Value Line Arithmetic Index, and the small-capitalization Russell 2000 Index have been trading more than 20 percent below their respective peaks. With most U.S. stocks already in bear territory, it seems that the larger-capitalization indices are being buoyed by price strength in just a handful of mega-cap stocks, for example Facebook, Amazon, Netflix and Google (the so-called FANG).
The causes for short-term concern for Merrill Lynch Global Research point to three fundamental red flags for markets in the short run. One is earnings revision ratios. Analysts have been revising earnings estimates downward for five straight months. As of late December, there were almost twice as many downward as upward revisions, making a short-term bounce, known as the “January effect” this time of year, less likely. Another is earnings vs. sales divergence. A high proportion of positive earnings surprises and negative sales surprises in the third quarter of 2015 made the gap between the two ratios the widest it has been since the first quarter of 2009.
Yet another is the gap between reported and adjusted earnings. Reported (GAAP) earnings have been lagging adjusted (pro forma) earnings by over 30 percent, well above the 2013-14 average gap of roughly 10 percent, and the widest gap since the 2008 global financial crisis. Encouraging technical and fundamental signals Wall Street strategists have been revising price targets down, and this has historically been considered a bullish sign.
According to Global Research’s contrarian Sell Side Indicator (SSI), strategists are as bearish today as they were in March 2009, with an average recommended allocation to equities of 53 percent, a significant underweight below its long-term average of 60-65 percent. At this level, the SSI is bullish, historically associated with a 12-month S&P 500 total return of 18 percent, and positive returns 96 percent of the time.
Global Research cites another contrarian indicator, the AAII Investor Sentiment Survey, which shows that only 18 percent of retail investors expect stocks to rise. This is the survey’s most bearish result since April 2005, even below its 19 percent reading during the 2008 crisis. Furthermore, the S&P 500 reached relatively more reasonable valuation (price-to-earnings) levels after the correction. Forward consensus values are all below their respective 20-year averages and March 2000 highs, but remain above their respective March 2009 lows (see Exhibit 1). According to Global Research, these valuations are pricing in a 50-percent probability of a recession.
Bear markets and recessions in historical context Whether we are entering a bear market or are already in one, we believe it would be classified as cyclical, not secular, but how severe could it be, and how likely is an economic recession to follow? With the U.S. economy projected to maintain modest growth, we expect a deeper pullback by the major equity indices toward or into bear territory to be shortlived, based on historical statistics.
Global Research identified 13 bear markets since 1928. They lasted an average of 21 months and had a mean peak-to-trough decline of 40 percent. Ten of those bear markets were associated with economic recessions, typically preceding them by one or two quarters, with the S&P 500 peaking seven or eight months before a recession. Those bear markets had a longer duration (26 months) and a deeper decline (43 percent) on average. The ones not associated with a recession were relatively short, averaging six months in duration, and shallower, with a mean 28 percent decline.
At this juncture, we believe the likelihood of a recession seems fairly low, as data suggest the U.S. economy remains healthy. Even though the manufacturing sector is contracting, as indicated by the manufacturing PMI, and Energy remains in a prolonged profits recession, the services sector, which accounts for roughly 80 percent of gross domestic product (GDP), is expanding, as indicated by the services PMI. Consumer spending remains robust, though it is not growing as it was 12 months ago, and when factoring in the recently approved government spending, we expect 2.0-2.5 percent real GDP growth in 2016.