The S&P 500 is on the cusp of a bear market - is it really this bad?

December 25, 2018

The S&P 500 is on the cusp of a bear market – is it really this bad?

If we wanted to try to find some kind of holiday-appropriate description for the stock market this Christmas season, I suppose it would make sense to compare it to the infamous Grinch from from Dr. Seuss’ How the Grinch Stole Christmas. It certainly seems that as we moved from Thanksgiving into December, much of the prevailing tone and sentiment in the market turned increasingly sour. Even yesterday, on a holiday-shortened trading session traders seemed to chose to emphasize the negative, focusing on the prospect of a long government shutdown and the job security of Fed chair Jerome Powell.

With yesterday’s decline, the market is now at a point where even technical traders are going to start using the term bear market more freely. Are things really as bad as they seem? If you pay too much attention to market news and popular media, or to Donald Trump’s latest Tweets, you might think that is exactly the case. I do think that it is true right now that the market is at another important tipping point, and that means that short-term downside risk is high. If you’re a patient, long-term investor, however, and short-term volatility doesn’t terrify you, it’s also worth noting that the market is offering up an increasing number of stocks at or near 52-week lows, and reaching levels that are starting to look like incredible bargains.

I don’t think the time is right to simply start buying into the market every time you find another stock that you think it trading at bargain levels; but there are some good reasons to keep an eye for value and to take a selective approach to buying to new opportunities even in current market conditions.



One interesting aspect of late-year trading that I don’t think is getting a lot of attention amidst all of the noise and hand-wringing over the last geopolitical events or Trump-worthy sound bite is something that is a yearly phenomenon in the market that has come to be known as the January Effect. An increase in selling activity isn’t all that unusual at or near the end of year, because that is investors when looking to save money on taxes from capital gains will usually start closing out losing stock positions. 

The reason this is called the January Effect is because after December, buying often increases as investors who cashed out the month before start looking for new places to put their money to work for them; it can also be attributed to things as simple as New Year’s resolutions to start investing for the future or to start a new investing program.

I think this theory tends to be less prevalent during the extended, clearly upward phases of a long bull market; the last couple of years are good examples, since the major indices at the end of both 2016 and 2017 didn’t really experience any kind of significant downward pressure at all. I think the reason is simple; investors were seeing healthy gains, with a clear, strong, and sustainable trend to follow, so staying in for the ride wasn’t a hard decision to make.

Fast forward a year, however, and how you have a market that experienced a myriad of swings from high to low, with two separate sell-offs into correction territory over about nine months of time. A lot of the stocks folks had been holding for the last several years have been even further off their all-time highs than the stock market is right now, and that means that in many cases there are some interesting reasons to think about closing out those negative positions to lock in a loss and apply it against taxable capital gains. I can’t help but wonder how much of the selling we’ve seen this month can be attributed to simple, end of the year tax planning strategies versus actual bearishness about the economy and the market in general.



I think it’s important to warn you about discounting the market’s volatility and drop over the last two months too much as a result of tax-motivated selling by too much. The truth is that no matter what is driving it, at some point a market decline goes far enough that the question stops being about why it’s dropping. More and more people see the drop, look at their accounts and simply decide it’s gone further than they’re willing to deal with. When that happens, they decide to sell as well, and that is the point when the market selloff really begins in earnest.

Here’s the latest chart of the S&P 500 to try to put the market’s latest drop in context, and to illustrate how much near-term risk I still think there is to be aware of right now.

 

This chart covers the last three years of market activity. I’m using the horizontal green line to illustrate the latest support level, based on historical pivot highs and lows in the fall of last year, that the market just broke below as of yesterday. Assuming the market keeps dropping after the market reopens tomorrow, that marks another break below support. I’ve used the yellow and blue lines to identify other areas where the market could show some signs of stabilization, but to be truthful, I don’t expect them to hold very well at all. I think it’s much more likely that market’s next most likely stabilization is about inline with the horizontal red line I’ve drawn.

The ~7% number I put on the chart above that red line marks the distance between the market’s close on Christmas Eve and where I think that support is going to lie. That’s still about 7% below the market’s current level, which means that in a broad sense, downside risk is still pretty elevated in the short term. A drop to that level would put the market well into bear market territory, and you can bet that if we get to that point, it will be pretty hard to find anybody with much of anything positive to say about the market.

In the long-term, I remain very bullish about the stock market, but that is because my own investing experience has taught me that there is no better tool for building long-term wealth than the stock market. In the short-term, I think bearish sentiment is going to rule the day, and so even as I keep finding and highlighting stocks that are trading at major discounts to their intrinsic values and the fundamentals that dictate the quality of those values, I’m going to be very cautious about taking on new positions. In many cases, my preference is going to be to wait for the market show me some signs of near-term stabilization while those stocks are trading at deep discounts. It’s true that a good value investor doesn’t shy away from good opportunities when we find them, in any market environment; but I also think that it’s smart to think about current market conditions as they relate the stock you’re thinking about, and to decide whether those conditions translate to volatility or additional risk that you are willing to ride through and work with.