Has The Stock Market Bear Returned?

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Last week’s sudden increase in volatility represents a change in character for the stock market that is not good news for the bulls.

I issued earlier warnings about the bear returning to Wall Street in this post and this post where I pointed out the risk to reward relationship for the stock market was extremely unfavorable. Both Gold and the Dollar reversed trends way back in December and confirmed their new direction this past week. Now it is time for the stock market to play catch-up.

If you remain unconvinced of this thesis then the next confirming signs that the credit crisis is returning would include expanding credit spreads, mortgage delinquencies (RealtyTrac reported last week a 14% increase from November to December), foreclosures and declining real estate prices. Already certain key indices failed to confirm the recent January rally by making lower highs and would be a confirming negative indication if they broke to new lows. Some specific indices to watch for this behavior include:

• $BKX (Bank Index – Philadelphia)
• KBE (KBW Bank ETF)
• LQD (Ishares Investment Grade Corporate Bond Fund)
• $CRB:$GOLD (Declining trend indicates rising fear and declining confidence)

As I stated in this post, I believe we are in a deflationary bear market. The rise from March 2009 to the recent high was a bear market rally. The major trend is down and the fundamentals continue to deteriorate.

The appropriate investment strategy for a deflationary investment environment will probably feel uncomfortable to many of you because your investment experience has been limited to inflationary bull markets. During those conditions the profitable strategy is to buy the dips and hold for the long term. A deflationary bear market is completely opposite – not just in terminology but in profitable investment strategy as well. The objective is to reduce exposure to risk assets (rather than hold for the long term), and to sell rallies to raise cash and de-leverage (rather than increase leverage into risk assets on declines).

I see far too many people still fighting the last battle when investment reality has changed creating a whole new war. Don’t make the same mistake.

History tells us that a deflationary credit collapse will not end until the debt destruction from the previous credit bubble has eliminated enough debt and lowered risk asset valuations to the point they are supported by cash flows. We are nowhere even close to that situation yet. We haven’t even gotten warm.

John Mauldin published an interesting article over the weekend consistent with this thesis that you may want to read. It discusses an important book currently in my reading pile This Time is Different: Eight Centuries of Financial Folly that I want to do a complete book review on later this year. It is important. However, the timeliness of these issues is so compelling right now that I don’t want you to miss out so I encourage you to pick up some of the key points from this link or pick up your own copy of the book as shown to the right.

I believe we are in for a rough ride in the years ahead. Risks are rising from areas nobody expects and few understand. We will explore many of these issues throughout the year in future posts, but for now the message is clear…

This is a very dangerous time for financial leverage, and it is a very good time to reduce risk exposure for most investors. Forewarned is forearmed.

Further Reading

• This Time is Different: Eight Centuries of Financial Folly
• Is This Just A Recession Or The Greater Depression?
• Stocks Offer Unfavorable Risk/Reward Ratio