50% Chance of a Bear Market (01/18/2016)

After the bears pounced on Thursday’s rally and plunged the market below key technical levels on Friday (including the 4150 level on the NDX that I discussed earlier and the August low on the S&P 500), I have decided to neutralize my stance on the U.S. stock market. Originally, I thought that I would turn decisively bearish if we got action such as what happened on Friday. However, I have decided that calling a bear market is still premature due to economic factors that I discuss later in the post.

I’ll lay out both the bearish case and the bullish case for the longer-term trend.

The Bearish Case

If the bull market is still underway, it should be in its 5th wave now. However, the market’s strength and breadth tend to weaken during the 5th wave rally, and 5th waves are known to sometimes be rather short compared to the 1st wave and the 3rd waves. Thus, if a 5th wave rally gets interrupted by unusually strong downward activity like we have seen recently, it is a warning sign that the bull market might be over.

The fact that the S&P took out its August low is not too big of a concern in and of itself given that the S&P has had the murkiest wave patterns ever since 2009. The concerning factor is the extreme downward velocity on all of the major indices, and the fact that the Dow and S&P are in declines of magnitude greater than any non-Primary degree decline in this bull market except for Apr – Jul 2010.

A potential bullish argument would be that in the bull market, the Dow and S&P did not have a Primary 5th Wave rally to new highs. However, the NDX did make a new high in Dec. 2015, and given that the NDX has had the clearest wave patterns in this bull market, the fact that it made a new high could signal a completed bull market.

The following chart for the NDX shows a wave count for a complete bull market.ndx complete bull market count jan 2016

The Bullish Case

Prior to the current decline in stocks, my outlook was that the bull market would continue at least until December 2016 based on long-term patterns and proportionality with previous waves of the bull market. I think that the only thing which could cut the bull market short would be a recession. However, right now the Treasury Yield Curve suggests that a recession is not imminent. The yield curve shows how the yields on Treasury Securities vary depending on the maturity lengths. The idea is that, normally, the yield curve should be upward sloping (meaning that yields on long-term securities are higher than yields on short-term securities), but if the yield curve is downward sloping, it indicates heightened risk of a recession. Historically, recessions have usually been preceded by downward-sloping yield curves. The yield curve typically flattens out or slopes downward in the late stages of a Fed rate-hike cycle.

Here is a website where you can see the Treasury Yield Curve at different points in time.

Note that the yield curve sloped downward in 2000 before the 2001 recession. The curve sloped downward in early-2007 prior to the 2007-2009 recession.

The yield curve has been steeply upward sloping throughout the current economic recovery, including the present time, suggesting that a recession is unlikely in the coming year.  If we are not going into recession, then it is difficult to conclude that the bull market is over.

Another factor to consider is the unemployment rate. I typically use the U6 rate for analysis rather than the headline U3 rate since the U6 is a more comprehensive indicator. Prior to both the Mar-Nov 2001 recession and the Dec 07 – Jun 09 recession, the U6 rate was rising by several basis points months before the recessions commenced.

In our current situation, the U6 rate has only risen one basis point since its most recent low of 9.8% in October 2015. There have been several rises of small magnitude along the way during its decline from 17.1% in April 2010, so the current one-point uptick does not mean much for economic outlook. If a recession is coming, I expect that the U6 rate would continue rising from here.

Regarding the stock market, last week I mentioned a potential Elliott Wave count that is promoted by some analysts, which is that the current decline is the C wave of a downtrend that began in May 2015. In that case, the August 2015 lows would get taken out, but the drop would still be a correction within an ongoing bull market.

Last week I said that I considered this wave count unlikely given that, historically, a 15-20% drop in isolation is usually enough to complete a bull market correction, and that in 2000-01 and 2007-08, after a drop of that magnitude had its lows retested, a bear market ensued.

However, as I thought about this some more over the weekend, I accounted for some contrasting factors between the current economic situation and that of previous periods. For instance, the economic growth right now is substantially weaker than it was during years like 1998 when we had those isolated corrections. Thus, maybe an extended correction is to be expected in our present situation. Furthermore, in March 2001 and June 2008, when the market had fateful breaches below major lows, unemployment was trending upward. However, in our current situation where the market is retesting recent lows, there has not been any significant rise in unemployment.

All things considered, I think we are in a very ambiguous situation now where historical precedent is not a clear guide. I am going to hold off on making any calls until seeing what happens in the coming weeks.

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