Bearish Sentiment — Time For Patience, Not Panic

This article was originally published on at 10:00am EDT on Jan 25th, 2016

The current correction we are experiencing has been much scarier than others in the post-crisis era. No corner of the market has been spared. Both professional and individual investors seem to be confused about, well….just about everything, including what exactly is causing the selloff.

Headlines seem somehow more ominous today than they were in 2011 when Europe was imploding for the first time, or in 2012 when there was a very real slight possibility of a temporary US debt default, or in 2014 when Europe was imploding again. What makes today’s headlines so scary is that none of them assign any rational explanation for the market to be aggressively selling off.

The reality, though, is that what we are experiencing is more likely part of a very normal pattern for the market. In fact, since 1980 the average annual drawdown for the S&P 500 has been 14%. That means that on January 1st of every single year, investors should be prepared for the market—at some point that year—to decline from a high point to a low point by 14%. That’s more than we’ve lost during this correction.

To me it’s a little silly to determine whether we are in a “bull” or a “bear” market… Despite me personally not believing that it much matters, these terms are thrown around constantly in the financial media—so I want to at least point out a couple of reasons why I don’t think it’s relevant.

A bull market is defined as a period of time after an equity or commodity index has gained 20% from its most recent low. Conversely, a bear market is defined as a period of time after such an index has fallen 20% from its most recent high. Whether or not we are in a bull or bear market does nothing, in my opinion, to help determine whether buying or selling is likely to be the correct next move.

Do I want to buy into a security or industry that is in a bear market? I guess that depends on my view about many things, but is there a time when it’s not smart to buy something that’s on sale? Sure—if there is strong evidence suggesting it will get cheaper, or much cheaper, in the future.

The S&P 500 is down (-8.25%) from its recent high on December 29th and (-10.5%) since last year’s high on May 21st. So, at no point in the past year have we been, technically, in a bear market. But since last year’s high in May several sectors, individual stocks, and other major indexes have, in fact, fallen by more than 20%—and have therefore entered bear markets. I’m not going to get into this too much here, as this subject would easily be sufficient for an entire blog. Look no further than anything associated with commodities, biotech, or banking.

How about sentiment?

Below are the results of an Investors’ Intelligence Sentiment survey taken on Thursday, Jan 21 (one day after Wednesday’s washout low)…

Higher prices lead to readings of more bulls; lower prices lead to readings of more bears. You can see Thursday’s reading was the third highest (in terms of bearish sentiment) since January of 2009, indicating extreme pessimism. These readings, without fail, have led to near-term market rallies in the past. Why is that? Because if I’m bearish, I’ve likely already sold my positions—or at least the ones I am willing to sell at these prices—and that means the selling is drying up.

Below is a graphical demonstration of sentiment lows overlaid with the S&P 500 performance over the past six years.

What about all the bad news out of China?

China is a mess, and we’ll never see another positive data point from that part of the world again.

At least this is what the media’s negative feedback loop would like you to believe. But one important point seems to be getting conveniently left out.

The US stock market is a reasonably good barometer for our economy’s strength (or weakness), at least as a leading indicator. The market capitalization of the entire US stock market is about $20 trillion, and our nation’s annual GDP is about $19 trillion. So our stock market is worth more than a full year of our country’s gross economic output. It makes sense, then, that our market ought to be seen as an accurate reflection of our economy.

In China the situation is quite different. China’s annual GDP last year eclipsed $11 trillion and is on pace to hit $12 trillion this year. The market capitalization of their stock market, though, is less than $7 trillion, and indisputably a less mature market than that of the US. So while it’s true that their stock market underwent a massive correction last year, their economy did not. It’s common knowledge that China’s actual GDP growth rate is questionable—data coming from a Communist nation is simply not as scrutinized as ours is—but there is no reputable source suggesting Chinese GDP is contracting.

The most skeptical estimates I’ve seen suggest China is “only” growing at 4-4.5% (as opposed to the 6.9% they recently reported for 2015). That’s a rate that would be considered enviable by any other major economy—and China happens to be the second largest in the world. Is China still a driving force for global growth? Absolutely. They are merely in the process of maturing from a manufacturing/export led economy to one in which services and consumption play a larger role.

So what’s causing the darned selloff?

As usual, uncertainty is a pretty good bet. In this case I would argue it’s uncertainty about oil—the most used and traded commodity in the world —which just so happens to be denominated in the most used and traded currency in the world (the US Dollar). The concern about cheap oil has nothing to do with consumers not spending their savings at the pump (which they are not doing, thus far). It is about the implied stress on the high yield bond market—almost 1/5th of which is related to energy—and the prospective bankruptcies/defaults, and their negative impact on the earnings of S&P companies.

To demonstrate just how correlated the S&P has gotten with oil, take a look at the two dancing side-by-side over the past month:

(Thanks to @ukarlewitz for the chart above.)

Did oil bottom on Thursday of this past week? We won’t know for at least another month, but the more sanguine rhetoric out of OPEC members in Davos suggests it is what they are saying (and not temporary supply/demand imbalances) that’s currently driving the bus. My guess is that those speculators who have been successfully profiting from low/declining oil are likely to pull in their horns with rapidity at the first sign of prices moving against them. Oil rallying on Thursday and Friday of this week, despite an inventory build (data that would have been seen as bearish a month ago), may be something for bulls to hang their hats on for now….

The bottom line is what we have just seen is not out of the ordinary, despite all the headlines suggesting otherwise. In fact, it shouldn’t be surprising if we see higher prices, maybe much higher, in the near future.

If you are scared by either the headlines or falling prices, you are not alone. But the exhaustive collection of data we are reviewing suggests it’s a time for patience, and not panic.

Please don’t hesitate to reach out with questions about your portfolio, whether or not it is held with our firm.

Adam B. Scott
Argyle Capital Partners, LLC
10100 Santa Monica Blvd, #300
Los Angeles, CA 90067
(310) 772-2201 – Main

Adam Scott’s profile on RealMoney can be found here.