These 3 Bear Market Arguments Are Flawed by Tony Mermer Chou

We developed a long term S&P 500 model that predicts bear markets and bull markets. Our model does not use traditional technical analysis because technical indicators do not cause bear markets or bull markets. We define “bear markets” as declines that exceed 33.33% and last more than 1 year. We deem the standard definition of a bear market – a 20% decline – to be a big correction.

Bear markets begin for one of two reasons:

  1. The market was in a bubble and that bubble is now popping.
  2. The U.S. economy was dealt a devastating blow.

We use valuation indicators to determine whether the market is in a “bubble” or not. For a market to be in a “bubble”, it must smash through its previous highs by multiples. For example, this means that if $100 was bubble territory 20 years ago, it will be considered “normal” valuation today.

It is more difficult to predict exogenous shocks that deal devastating blows to the U.S. economy. Since we cannot predict these shocks in advance, we can only predict a bear market when a shock has already occurred. Contrary to popular opinion, recessions do not cause bear markets. For example, there was a recession from July 1990 – March 1991. The S&P 500 corrected 20% and promptly resumed its bull market trend.

In order for an economic problem to cause a bear market, it must be significant enough to freeze the entire U.S. economy. This is what happened in 1973 when OPEC announced an oil embargo and the U.S. faced an imminent energy crisis. This is also what happened in 2008 when the financial system collapsed and credit completely dried up.

There are no reasons for a bear market to exist as of October 2015. The U.S. stock market is not in a bubble – it still has at least 3 years before it reaches a “bubble” state. There is also no economic shock that’s significant enough to deal a devastating blow to the U.S. economy right now.

In the rest of this post we’d like to debunk 3 popular bear market arguments going around the financial world right now.

Overvaluation Means Nothing

Yes, it’s true that stocks are “expensive” by historical standards. Tobin’s Q is a popular valuation indicator. This chart shows that the Q Ratio was relatively high by the end of 2014 (historically speaking).

Bear Market

However, overvaluation means nothing. Overvaluation is only a problem if the market reaches a “bubble” state. Our long term S&P 500 model states that a bubble can only occur after the market is “overvalued” by a minimum amount. So if the long term average Q Ratio is 0.8, a Q Ratio of 0.9 is indeed “overvalued” but is not problematic for the bull market.

An absolute Q Ratio of 1.09, which the market achieved 2014, is indeed high. Many historical bear markets began before the Q Ratio reached 1.09. However, we do not use the Q Ratio’s absolute value when defining what is and what isn’t a “bubble”. Instead, one of our indicators states that the Q Ratio must increase by at least 0.6 from the last bear market before the market can enter “bubble” territory. This means that the U.S. stock market will not be in a bubble until the Q Ratio rises above 1.17 during this bull market.

A Catastrophic Recession is Not About to Begin

Yes, it’s true that the U.S. economy is really slowing down. But this is a natural part of the business cycle. With the U.S. economy on fire in 2014, it’s perfectly normal that growth should diminish this year. Investors fail to remember that the economic recovery was in serious jeopardy in the summer of 2011. Most economic indicators pointed had turned south and Warren Buffett pronounced on CNBC that the economy had suddenly deteriorated in August 2011.

But neither a recession nor a bear market materialized after 2011. That’s why it’s important to remember that bumps in the road are perfectly normal during economic expansions. The following indicators provide ample reason to be optimistic about the U.S. economy right now.

  1. Despite weak employment reports for August and September, employment growth matches that of the 1990s (when the U.S. economy was booming). The average monthly employment increase over the past 12 months is 228k.
  2. Wages are still growing, albeit slowly.
  3. Activity in the real estate market continues to pick up. Housing is a key component to the U.S. economy. Although it’s a relatively small part of the economy, it’s highly volatile. Thus, any change in the housing market is going to have an outsized effect on the U.S. economy.
  4. Sales of large ticket items like autos are surging. Auto and Light Truck Sales in August hit a new high since this economic recovery began. Sales of large ticket items typically begin to decline for recessions begin.

I’d like to focus on the housing market because it’s the best leading indicator for the U.S. economy. For starters, the U.S. housing market is still in the very early stages of its recovery. Recessions typically do not begin when housing (and thus the economy) is just recovering. Remember, you can’t die by jumping out the ground floor window.

In addition, Housing Starts, New Home Sales, and Housing Permits have all recently made new highs since this economic recovery began. The housing market always turns down before a recession begins. So unless the housing market begins to turn south in 2016, there’s no reason to believe that a recession will begin.

If a global recession is not about to begin, it’s hard to see why the U.S. stock market will enter into a bear market.

There Are No Exogenous Shocks

Other bearish investors believe that problems in Europe and China will cause a U.S. bear market. Never before in history was a U.S. bear market caused by foreign problems. The U.S. economy is actually a relatively isolated economy that’s mostly immune to foreign turmoil. In the most extreme of situations, foreign turmoil can merely cause a big correction in the U.S. stock market.

  1. Europe’s been an absolute mess from 2010 to 2014. There was no U.S. bear market during this time.
  2. The Russian default crisis in 1998 triggered a 20% correction. There was no U.S. bear market.
  3. The Asian crisis of 1997 barely had an effect on U.S. stocks. There was a very quick 14% correction.

In addition, I wouldn’t be too worried about a Chinese hard landing. The Chinese government holds $3.51 trillion in foreign currency reserves. Such massive reserves leaves the Chinese government with ample firepower to fight off a hard landing scenario.