Global bear market at our doorstep?

Published June 06, 2012

MONEY MATTERS

Invest with caution because there are many warning signs of a correction ahead

By William Cai

EVERY bear market starts with a correction, and investors may want to take heed of the warning signs ahead.

MSCI World excluding USA in a bear phase

Firstly, while US equity indexes are still in a bull phase, global equities have reached a bear phase. In 2011, the MSCI World excluding USA index (MSWORLD) fell -26 per cent from its peak in April but by December, it bottomed out and recovered.

Unfortunately, its rally was short-lived as it fizzled out in March 2012 and the index fell below its 50-week moving average. From its peak in April 2011 to date, the index has fallen -26 per cent and is officially in a bear market.

When prices fall in excess of -20 per cent for a period longer than two months, such a condition is widely known as a "bear market".

Downward price momentum could accelerate and carry prices lower due to a confirmation of an ominous bearish "head and shoulders" pattern on the MSWORLD chart.

A break below its neckline could set an expected target for the index to head -28 per cent lower. This is a highly probable scenario if US equities were to fall further in the coming weeks.

S&P 500 negative divergence signals

Secondly, the S&P500 monthly chart is showing negative divergence signals and it serves as a warning of a potential bear market ahead. This signal occurred a few months before the bear markets in 2001 and 2008, and should not be dismissed.

A "negative divergence" is a case when indicators are pointing downwards as the price of the asset in observation is moving up.

The monthly chart of the S&P500 helps us focus on the longer-term behaviour of the market. A few months before the S&P500 fell sharply during the bear markets in 2001 and 2008, a "negative divergence" signal surfaced.

As the index was heading higher, the Relative Strength Index (RSI) and Moving Average Convergence and Divergence (MACD) indicators were pointing lower. The tipping point was when the index fell through the index's 16-month moving average line and ushered in an accelerated fall.

Now, a negative divergence has clearly resurfaced - as the index is moving higher, the RSI and MACD are pointing downwards. The index has just fallen through its 16-month moving average and with a MACD signal line crossover, they suggest that an accelerated fall is eminent and the S&P500, which is the world's most closely watched index, will likely lead global equities downwards.

Dow Theory non-confirmation

Thirdly, while the Dow Jones Industrial Average (DJIA) has surpassed its high seen in 2011 and remains in an uptrend, the Dow Jones Transportation Index, which is a more economically sensitive index, has lagged and started to trend downwards. This is a Dow Theory non-confirmation signal which suggests caution ahead.

In addition, the small-cap Russell 2000 index, which is a broader representation of the US economy, has not confirmed DJIA's rally. Small-caps stocks are seen as "soldiers" and if they fall, it would be a matter of time that the larger stocks known as the "generals" would fall too.

US new highs - new lows

Fourthly, market breadth analysis has shown that US stocks have deteriorated since 2011. The market breadth analysis is conducted using the NH-NL indicator, which studies the advance and declines issues of US stocks. The indicator is computed by counting up all of the US stocks that are making new 52-week highs and subtracting all of the US stocks that are making new 52-week lows.

In February 2011, the index showed a negative divergence from the NYSE Composite Index and that served as a warning that market breadth was getting weaker and equity markets saw a sharp drop in July. Once again, since February 2012, market breadth weakened as US stock climbed. Now the NH-NL indictor has begun to turn negative suggesting that the US stocks are ready to roll over into a bear phase.

Year-over-Year (YoY) GDP per cent change and current recession risk

Lastly, an observation from 1947 shows that when the YoY change falls below 2 per cent, a recession could likely follow a few months later. However, investors must note that the determination on recession start dates are always announced much later, after the bear market has occurred. The latest YoY real GDP at 1.99 per cent suggests that the bearish technical studies should not be taken lightly.

Conclusion

Now that I have planted a bear bug in readers' minds, they must be careful to avoid suffering from bearish confirmation bias - which would cause them to miss a stockmarket rally if market conditions improve. Equity markets are at oversold levels and could recover soon but if market breadth remains weak, any rally should be short- lived.

However, we could see a sustainable rally if the US Federal Reserve Board decides to introduce a third round of quantitative easing measures (aka QE3) after their meeting on June 19-20. In addition, as this is a presidential election year, the US president could activate the "Plunge Protection Team" to positively rig the market and surprise us on the upside before the November elections. Likewise, other global policymakers like China could also launch policies to stimulate their economy while the European Union is also on standby with a US$1 trillion "firewall" to fight the financial contagion from the region's ongoing debt crisis.