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Don't ignore the chance of a 'mild' bear market

Michael Santoli
Michael Santoli

The suddenly violent market has spun investors’ heads around. Ideally this is forcing them to consider a broader range of possible paths ahead for stocks.

Wednesday’s powerful, if overdue, 4% bounce in the big indexes relieved the immediate pressure. But it’s a reprieve, rather than a pardon, for a tape that has relinquished the benefit of the doubt.

The S&P 500 (^GSPC) failed even to climb back to the high of the prior day’s badly failed rally. The 619 points the Dow (^DJI) rose yesterday represent less than a third of the ground it lost in the prior week.

If the main requirement for a decent bottom in stocks was a fearful and confused investing crowd, we’d be pretty close.

The demand for downside protection in the form of index put options and bets on surging volatility has reached historic levels. The weekly Investors Intelligence poll of investment advisors showed the lowest number of professed bulls in five years. The CNN/Money Fear & Greed Index is deep in Extreme Fear territory.

And of course the complicated interactions of Chinese stocks, emerging-market currencies, hedge-fund forced liquidations and potential policy responses by central banks are daunting to contemplate and nearly impossible to sort out.

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The standard Wall Street strategist take on all of it, though, is that this is a “healthy correction,” the 11% setback just about enough to refresh the 30-month bull market. We hear plenty of talk that it’s “too late to get bearish,” usually form pundits who never got bearish before the market tumbled 10% in a week.

Then there’s the reliable doom-and-disaster contingent, which has rarely seen a stock market that couldn’t stand to be halved, or an official policy move that wasn’t 180-degrees wrong.

But another, in-between scenario doesn’t seem to get enough play along the probability spectrum of what could be next: A cyclical bear market – perhaps twice as damaging as the correction so far but not the devastating meltdown we got in 2007, and before that in 2000.

Such mini-bear markets – sometimes not accompanied by a U.S. recession or lasting wealth destruction – used to be more common, before market cycles started to elongate in the ‘80s and ‘90s.

A few days before the steep selloff struck, Jonathan Krinsky, a technical strategist at brokerage MKM Partners, circulated an interesting chart that matched the S&P 500 since 2012 with the path of the 1962-’66 pattern. They synch up quite well.

While such analogies are properly met with some skepticism and Krinsky himself isn’t insisting it’s predictive, that market ended with a brief 22% bear market - with the U.S. economy still growing – whose losses were recouped within less than a year.

Doug Ramsey, chief investment officer of Leuthold Group, told me in late 2013 that he thought the 2100 level on the S&P 500 could be an interesting place for the bull to stop, representing the inflation-adjusted all-time high from years earlier. That’s around where the record high now sits.

Ramsey’s been viewing the market as undergoing a topping process for months and thinks a cyclical bear retreat have begun. While he uses no firm downside targets, he notes that a drop to the 1700-1750 range on the S&P 500 would return the index to its long-term median valuation relative to corporate earnings. A drop to 1700 would mean another 12% loss and a 20% decline from the top.

If the May high were to prove the peak of this bull cycle, it would rank among the stronger and longer ones in history, and would have reached a fairly full – if not historically egregious – valuation. So the market hardly owes investors much more than it’s delivered.

On the other hand, if May were the ultimate top, this bull phase would have ended with a meek whimper rather than a final party.

Keither Lerner, strategist at SunTrust, notes that if indeed May 21 was The Top, the three-month gain of 1% leading into it would represent the weakest bull-market finale of the postwar era. And its six-month rise of 2.8% would rank as the second-worst “last hurrahs” of the 13 bull markets since 1945.

So the weight of the evidence doesn’t clearly net out to the conclusion that this turbulence will deepen into a full-fledged bear market. And I've mused on the prospect that this bull's days were numbered before with stocks somewhat below today's level in October. But it makes sense to be informed by the full range of possibilities that history and human nature suggest are in play.

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