Understanding the next bear market
Published: August 2016
Updated: January 2019
We provide insight and information regarding the key indicators that signal a major stock market decline and a possible recession.
Since August 2016, we have focused on understanding the extent to which a major stock market decline may take off. In August 2016, our forecast was that we would begin to see signals for a potential Bear market at the end of 2018 to the beginning of 2019. We have since informed our customers, through our analyzes, of an increased risk of a recession sometime between 2019 -2021.
We believe that the major downturn has not yet taken off, but we can see that market turmoil has increased and will become increasingly evident the further into 2019 we will be. The upcoming crisis we have chosen to call "the All Inclusive Crisis". For a long time we have studied the variables that we consider to be the most important indicators and which strengthen our view of the future stock market decline and possibly a subsequent recession.
In a series of publications, we will have a more technical perspective while subsequent publications will address more fundamental factors.
For some time now we have been skeptical of the argument that the US economy is going strong due to fundamental factors, which many point out as the reason for the strong stock market upswing we have seen since the last financial crisis of 2008. We are of the opinion that the strong stock market upturn is instead built on “Cash on Steroids and Cheap Money”, ie the central banks' expansionary monetary policy in the form of record low policy rates and quantitative easing programs, and an expansionary fiscal policy containing tax relief and deregulation.
This can be seen quite clearly when the stock exchange has now reacted strongly negatively when the US Federal Reserve Federal Reserve (Fed) has started its normalization of the balance sheet by allowing securities to mature rather than reinvest these liquid assets.
"We are of the opinion that the strong stock market upturn is instead based on" Cash on Steroids and Cheap Money ", ie the central banks' expansionary monetary policy"
The historical crises and the S&P 500's movements
1929 The Great Depression: The crash came after a sharp expansion during the 1920s when total American wealth doubled. Speculating in equities became commonplace and many were relieved to increase the size of the positions with leverage (trading on margin). After the peak on September 16, 1929, panic increased in avalanche and to the bottom on June 1, 1932, S&P had dropped 86.19%. The stock market crash was the start of the worst economic downturn during the industrial era.
1987 Black Monday: S&P falls by 20.47% on a single day and will be remembered as "the Black Monday". The causes of the crash are many and have been widely debated. The most prominent reasons have been explained by, among other things, the start of computerized trading, that is, the beginning of advanced algorithmic trading. In this case, the computers were programmed to sell at specific levels, resulting in a self-fulfilling crash when sales orders after sales orders triggered each other.
1990 Junk Bond Crash: The crash came after a long period of deregulation, which among other things spread junk bonds (Junk Bonds) around the world. What would later be identified as the catalyst for the crash was the canceled UAL purchase of $ 6.75 billion. The big domino til came shortly afterward, the bankruptcy by one of the fifth largest investment banks of the time in the US, Drexel Burnham Lambert. The bank's large and illegal involvement in junk bonds created chaos.
1998 Tom Yung Goong Crisis: The crash was largely based in East Asia and especially Thailand. Foreign capital had flowed into these emerging economies, but as growth slowed, capital sought more high-yielding regions. For Thailand, this ended with the Thai state being allowed to release the Thai bath floating (previously pegged to the US dollar) due to an oversupply of foreign currency which made it impossible to defend the value of the bath. The turmoil quickly spread to the rest of the world's stock markets because of the spread effects.
2000 Dot-Com Bubble: Like many other crashes, this one was also based on a single sector that has been inflated. This time, the new hope was the technology and internet-related companies. The hysteria became so great that many people forgot that the companies were not sustainably profitable and in most cases not profitable at all. Once interest rates came up and the economy began to slow in, the risk capital inflow came to an end which had been the fuel for the sharp upswing. Many of these Dot-Com companies went bankrupt or liquidated while very few survived and grew larger.
2008 Global Financial Crisis: A crisis that developed into a large-scale global system crisis. The hype and greed in the credit and derivatives markets led to large institutes' bankruptcies, while others succeeded thanks to large government support. It was not only system critical institutions that were moving in the same direction, but entire economies. This crisis has been called the worst since the Great Depression in 1929. The American dream of owning his own house combined with a speculative financial market, disastrous credit institutions, and investment banks that became dependent on this lucrative market eventually led to the crisis.
"The second longest and strongest bull market is the current upswing that started after the global financial crisis in 2008"
Bull markets with the subsequent bear market that led to a recession. How long did they last and what was the percentage change?
The strongest bull market was seen in the Dot-Com hype. The rise of the Dot-Com was clearly a fundamentally unjustified development. The second longest and strongest bull market is the current upturn that started after the last financial crisis in 2008. We are convinced that this upturn, which, as previously mentioned, is largely based on artificial conditions, has created a market climate with high risk appetite.
The worst bear market, seen as a percentage decline, is the Great Depression in 1929. The S&P 500 then went down by 86.19% and lasted for 707 trading days. The second worst bear market seen as a percentage decline is the latest financial crisis that started in 2007 with a decrease of 57.69%. If we instead focus on the number of trading days that the downturn lasted, the Dot-Com crisis is the second worst with 645 trading days.
"By studying the previous recessions we can get a better picture of what we can expect in the future"
A hit-proof recession indicator, the US government bonds
The yield on the US Treasury note with a maturity of 10 years (US10Y) is a good indicator of market sentiment and risk appetite. When confidence is high, the yield on the US10Y goes up as investors seek more high-yielding asset classes associated with higher risk. Conversely, yields go down when investors' confidence is low and increased demand for safer asset classes is high, which means that the price of the US10Y goes up. The US10Y also acts as a safe haven as the geopolitical turmoil increases.
In other words, the US10Y price/yield is largely driven by the market's view of the future, while the short-term Treasury bills are more governed by the Fed's monetary policy. Negative yield spreads occur when the market believes in a more pessimistic future, that is to say, towards “safe haven” in the form of long-term interest rates, while the central bank raises its reference rate, to cool down the economy, which drives up short-term interest rates.
A negative yield spread between Treasury bills and long-term rates is also usually referred to as an inverted or negative yield curve, since Treasury bills with shorter maturities have a higher yield than long-term notes and bonds.
Historically, negative yield spreads have been a reliable indicator of recession. By studying the previous recessions we can get a better picture of what we can expect in the future. Below we look at the time when selected yield spreads have become negative as well as when historical recessions have taken place, as shown in the gray columns.
"The historical crises have arisen when the Fed started lowering interest rates, causing the yield curve to quickly turn upward"
The yield spread between the 5-year Treasury note (US5Y) and the 3-year Treasury note (3-year) became negative on December 3, 2018 (ie the yield on the US5Y became lower than the US3Y). When this has happened historically, it has taken 795 days on average until the S&P 500 reached its peak. At present, we see a higher probability that the peak is set earlier than the historical average indicates.
The yield spread between the US10Y and the 2-year Treasury note (US2Y) gives us additional data for our projection for the coming recession. When the spread has historically been negative, it has taken 686 days on average to the S&P 500 peak. Our model shows that the yield spread should be negative in about 109 days. However, the fundamental picture can change rapidly and a negative yield spread can occur faster than our model shows due to the current troubled market climate.
The yield spread between the US10Y and 3-month Treasury bill (US3M) has been one of our key indicators for projecting the next recession. When the yield spread becomes negative, it has historically taken 575 days on average until the S&P 500 peaked. The recession will drag on after the market downturn. From the current level, we see that the yield spread can be negative within 111-220 days.
The Fed policy affects inversion
Uncertainty about the economic downturn is starting to become the bitter reality for investors seeking returns. This has contributed to the fact that Treasury notes and bonds have become a more attractive asset with their safe haven status. When investors carefully allocate to government bonds, the interest rate is pushed down, and combined with the Fed raising the policy rate, the 3-month T-bill rate follows up, which increases the risk of a negative yield spread.
However, it is not the yield spread itself that creates a recession, but the historical crises have arisen when the Fed started lowering the interest rate, which causes the yield spread to quickly turn upwards as short-term interest rates quickly fall and increase the spread. This is shown in the picture below as the yield spread has become negative, they then turn up sharply while the S&P 500 goes down.
"...when the yield spread between the US5Y and the US3Y has become negative, it has historically taken between 407-678 days...until the S&P 500 reached its peak."
Compilation of historical yield spreads and the S&P 500's peak
The negative yield spread on selected US Treasury notes gives us a starting point to calculate how long it will be until the market sets its peak, a major stock market decline, and a potential recession. In terms of time, it has historically been consistent 1 to 2 years between a negative yield spread to the S&P 500 reaching its peak. The difference is of course determined by the market and macroeconomic circumstances. In the graph, the purple column represents the S&P 500's peak while the gray columns represent recession.
The table shows the dates when the spread between the US5Y yield and the US3Y yield has historically been negative and also how many days it took until the S&P 500 reached its peak. On average, it has taken about 513 trading days based on the following crises.
The table shows the dates when the spread between the US10Y yield and the US2Y yield has historically been negative and also how many days it took until the S&P 500 reached its peak. On average, it has taken about 438 trading days based on the following crises.
The table shows the dates when the spread between the US10Y yield and the US3M yield has historically been negative and also how many days it took until the S&P 500 reached its peak. On average, it has taken about 362 trading days based on the following crisis.
Based on the above data regarding when the yield spread between the US5Y and the US3Y has become negative, it has historically taken between 407-678 days, or an average of 513 trading days until the S&P 500 reached its peak. This is based on the Junk Bond Crash, the Dot-Com Bubble, and the Global Financial Crisis. Since only this yield spread has become negative at the time of writing, we only assume it at the projection of this cycle's peak. Below you see the yield spread between the US5Y and the US3Y (green line) and the S&P 500 (black line) and projection on when the S&P 500 reaches its peak based on the negative yield spread and the three previous crises peak.
The green line shows the yield spread between the 5-year Treasury note and the 3-year Treasury note, while the black line shows the S&P 500. Based on the historical negative yield spread between these two T-note rates, the S&P 500 has reached its peak on average 513 trading days after this occurred. The three dashed lines show when in time the S&P 500 reaches its peak based on the last three times this has occurred (January 12, 1988, July 23, 1997, and December 19, 2005). The number of trading days has then been added for each individual case since the yield spread became negative on December 13, 2018. More specifically, these dates are July 8, 2020 (Junk Bond), September 14, 2020 (Global Financial), and July 22, 2021 (Dot -Com).
"-10% signal is a theoretical indicator that should be considered an interesting signal factor, but many other factors have more important indication strength and impact on the market and the economy"
-10% signal, a warning signal before major stock market decline (> 20%)
Every crisis since Black Monday has provided a recurring pre-indication of a major stock market decline and that is a correction of at least -10% before the bull market has reached its peak. After this peak (peak 2 in the table below) a bear market has then begun.
The table shows, for each individual cycle, the dates when the correction started (Peak 1) and ended (bottom) and the percentage decrease. “Bottom of Peak 2” indicates the percentage increase from the bottom of the correction to Peak 2 and the number of trading days. The three closing columns show when the absolute peak occurred, when the bottom of the descending bear market occurred, and how large the percentage decline was from high to low.
During the Black Monday cycle, the correction started on August 27, 1986 and bottomed on September 29, 1986 after a decline of 10.29%. From the bottom of September 29, it took 229 trading days to the bull market peak on August 25, 1987 after a 48.15% rise.
During the Junk Bond Crash cycle, the correction started on January 3, 1990 and bottomed on January 30, 1990 after a decline of 11.30%. From the bottom of January 30, it took 115 trading days to reach the bull market peak on July 16, 1990 after rising 15.62%.
During the Tom Yum Goong Crisis cycle, the correction started on October 8, 1997 and bottomed on October 28, 1997 after a 13.00% decline. From the bottom of October 28, it took 183 trading days to reach the bull market peak on July 20, 1998, after rising 39.21%.
During the Dot-Com Bubble cycle, the correction started on January 3, 2000 and bottomed out on February 28, 2000 after a decline of 10.35%. From the bottom of February 28, it took 19 days to hit the bull market peak on March 24, 2000, after rising 17.21%.
During the Global Financial Crisis cycle, the correction started on July 16, 2007 and bottomed on August 16, 2007 after a decline of 11.91%. From the bottom of August 16, it took 39 days to reach the bull market's peak on October 11, 2007, after rising 14.99%.
During the European Debt Crisis cycle, the correction started on April 26, 2010 and bottomed on July 1, 2010 after a decline of 17.12%. From the bottom of July 1, it took 210 days to reach the bull market's peak on May 2, 2011, after rising 35.58%.
Peak may have already occurred based on the -10% signal
Since the bottom of the S&P 500 on March 6, 2009 after the “Global Financial Crisis”, the percentage development has been 341.05% and measured from S & P's peak on September 21, 2018, this cycle has lasted 2,405 trading days. Prior to this peak, we saw a correction of 11.84% between January 26 and February 9, 2018. Then it took 163 days for the peak on September 21 after an increase of 16.12%.
"However, all corrections of at least -10% in the cycles we have analyzed and presented in this publication have not resulted in any major stock market decline."
Corrections of at least -10% without subsequent major stock market decline
However, all corrections of at least -10% in the cycles we have analyzed and presented in this publication have not resulted in any major stock market decline. Below we present these corrections and in which cycle they took place and what the development looked like. In the graphs, the last data point represents the peak for each cycle.
The table shows when a correction of at least -10% has occurred without a major stock market decline. The column "Peak" and "Bottom" indicate the date when the correction started and ended. At the far right of the column indicates how many days the correction went on and the total decrease in percentage from high to low.
The graph shows when a correction of at least -10% has occurred without a major stock market decline. A correction of at least -10% occurred from mid-1984 to mid-1985.
The graph shows when a correction of at least -10% has occurred without a major stock market decline. A correction of at least -10% occurred from mid-2000 to Q4 2000.
The graph shows when a correction of at least -10% has occurred without a major stock market decline. Two corrections of at least -10% occurred in mid-1996 and in Q1 1997.
The graph shows when a correction of at least -10% has occurred without a major stock market decline. Two corrections of at least -10% occurred in Q2 2012 and in the middle to the end of 2016.
"Since 2016, we have warned our customers about the exact years when we believe the coming downturn will develop and a possible recession or recession"
What can the trend look like in the future?
At worst we have a trend similar to the Great Depression cycle, the Dot-Com Bubble cycle or the Global Financial Crisis cycle. In this scenario, we received the -10% signal at the bottom of the correction on February 9, 2018 and that the peak on September 21, 2018 is actually the peak before a longer bear market. In such a case, the bear market may behave in the following manner based on these three cycles.
In the graph, the black line represents the current trend in the S&P 500 since the beginning of 2017 to the present, while the other three lines represent the bear market for the Great Depression cycle, the Dot-Com cycle and the latest financial crisis, the Global Financial Crisis cycle. The top in all three cases has been set to value 100, ie the peak of the Great Depression cycle, the Dot-Com cycle and the Global Financial Crisis cycle has been implemented at the peak that occurred on September 21, 2018.
At best we have a trend similar to the Junk Bond Crash cycle or the Tom Yum Goong cycle. Similarly, we received a -10% signal at the bottom of the correction on February 9, 2018, but that the decline at the end of 2018 and the beginning of 2019 of -20.21% is only a major correction. In such an outcome, the continuation after the major correction has historically been implemented as follows on today's market trend.
In the graph, the black line represents the current trend in the S&P 500 since the beginning of 2017 to the present, while the other two lines represent the trend after the major corrections during the Junk Bond Crash cycle and Tom Yum Goong cycle. The peak in all three cases has been set to value 100, ie the peak on both the Junk Bond Crash cycle and the Tom Yum Goong cycle has been implemented at the peak that occurred on September 21, 2018.
"In future publications we will go deeper into the macroeconomic picture and study the Fed's monetary policy in more detail in previous cycles"
At the time of writing, the S&P 500 had a strong upturn from the bottom on December 26, 2018. In a bear market, there has historically been a strong relief rally and then to return to the downward trend of the bear market. The reason for this sharp and rapid rise is, we believe, a combination of technical oversold, a more dovish Fed as well as indications of success in US-China trade agreements. Technically, we saw the S&P 500 bottom out at the 2350 level where the index found support at a critical technical level from the low point on February 12, 2016, and 200 days moving average in the weekly graph along with demand zone.
Although the Fed has now raised the key interest rate nine times since the end of 2015 and chosen not to reinvest maturing securities in their SOMA portfolio reducing the balance sheet, they have recently become increasingly dovish in their statements. There is a clear correlation between the S&P 500 and the Fed's balance sheet, which was evident when the Fed began its normalization of the balance sheet, and the index quickly came down. The Fed Funds futures indicate that the market does not believe in any more increases by the Fed in 2019, but sees a higher likelihood of a cut.
The optimism that the US-China trade agreements are approaching a solution has also fueled the risk sentiment. On March 1, the deadline expires and if no trade agreement is signed before then, Trump has warned of raising tariffs on Chinese imports. However, Trump has given indications that the deadline can now be extended if a trade agreement is approaching.
On the upside, we are first and foremost monitoring the levels 2800 and 2854 which are important levels, and previous peaks at 2940. We are also set to reach new high levels if the Fed and trade agreements can continue to support the market sentiment. In the longer term, however, we remain very negative, as mentioned at the beginning, we see major risks of weakening in the US economy and that the market is held up by artificial respiration in the form of expansionary monetary and fiscal policy.
In future publications, we will go deeper into the macroeconomic picture and also study the Fed's monetary policy in earlier cycles.
Organization: Zaree & Partners AB
Title: Zaree Markets
Featured: August 2016
Updated: February 2019
Source / Data: Thomson Reuters Eikon / Datastream