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The signs are remarkably clear: A bear market in stocks is on its way, and it's time to bear-proof your portfolio as much as you can.
There are five things you must do sooner rather than later -- call them five rules for dodging the worst of the bear -- to protect your portfolio before the bear claws an additional 20% out of your stocks.
We won't be in an official bear market until stocks drop 20% or more from their October 2007 highs. That would mean a decline to the 11,250 level for the Dow Jones Industrial Average ($INDU), to 1,275 for the Standard & Poor's 500 Index ($INX) to 2,250 or so for the Nasdaq Composite Index ($COMPX).
- Talk back: Is a bear market rally close?
But frankly, I'm not willing to wait for this market to earn its official bear stripes. Waiting for a 20% drop means I don't start doing anything to protect my portfolio until I'm already down 20%. I'm willing to risk the chance that I'm wrong because the downside is so significant and because the evidence of an impending bear market in stocks is so convincing.
Here's what I see:
- The charts show a breakdown in the stock market averages and a strong downward trend. The Dow industrials, for example, show a dangerous pattern of reaching lower lows. Look at what happened after the Dow reached its low for 2007 on March 5. When a rally failed, the index hit a low of 12,861 on Aug. 15. The Dow rallied into October but then fell to close lower, at 12,743, on Nov. 26. On Jan. 8, it closed even lower, at 12,589, and it has kept falling. Just before noon ET Jan. 18, the index fell below its 52-week closing low and its low for 2007. The Dow isn't the worst-looking index, either. The S&P 500 broke through its March 5 low of 1,374 on Jan. 16, and the Nasdaq Composite closed Jan. 18 about 1 point below its March 5 low of 2,341.
Dow Jones industrials
- Fear is still rising. The CBOE S&P 500 Volatility Index ($VIX.X), which uses the volatility of options on the S&P 500 Index to track stock market volatility, is a good measure of fear in the market. A higher VIX indicates more volatility and more fear, a lower VIX the opposite. A break in the VIX below 17.5 in October 2003 showed the downtrend in fear that preceded the huge run in stocks that went on until 2007. The VIX bottomed at 10 in July 2005 and stayed in a trading range below 18 for the next two years. Last July, however, the VIX surged above resistance at 18 and broke above 30. After sinking back to 18 in October, the VIX has been on an upward march again. Fear is climbing, and that's not good for stocks. There are fewer buyers when fear is high.
- Wall Street earnings estimates are still way too high if the U.S. economy is headed into a slowdown. Bottom-up estimates for earnings growth for the companies in the S&P 500 -- the total earnings growth you get for the 500 companies in the index if you add up Wall Street estimates -- still call for 16.2% earnings growth in 2008. Estimates have been stubbornly slow to come down. The estimate for total S&P 500 earnings stood at $101 per share at the end of 2007. By Jan. 14, it had inched down to $100.32. As earnings estimates and earnings-growth estimates fall, stocks will seem more expensive, and that's not much of an inducement to fearful buyers. When even well-run segment leaders such as Johnson Controls (JCI, news, msgs) and Schlumberger (SLB, news, msgs) report disappointing earnings and guidance, as they did Jan. 18, those fears seem well-founded.
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- Global money flows that propped up U.S. equities are reversing. The debt market crisis that has sucked down banks such as Citigroup (C, news, msgs) and investment houses such as Merrill Lynch (MER, news, msgs) has prompted a flight to safety among traders who borrowed money cheaply in Japan and used it to buy up stocks and other assets in the United States, Europe, Canada, Australia and elsewhere. To repay their yen loans, traders are selling just about everything denominated in euros or in U.S., Australian or Canadian dollars. You can see the effects in falling asset prices and a rallying yen. A climbing yen just makes the problem worse, of course, as borrowers rush to sell to repay their yen loans before repayment becomes more expensive.
- Bad news is still getting worse in the key U.S. housing and banking sectors. For example, home construction fell 14% in December, and new permits fell 8%. In the banking sector, bad-debt problems continued to ripple out from mortgages to credit cards to auto loans to corporate bonds. (See my Jan. 18 column, "The next banking crisis is on the way.")
- And finally, many of the world's markets are moving down together, which is scary to traders who believed the damage would be limited to the U.S. As of Jan. 18, the Japanese stock market was down 26% from its mid-July high, the Hong Kong stock market was down 23% from October, the Shanghai stock market had tumbled 13% since October, and the Spanish stock market was down 14% from November. The sense that there's no place to hide is fueling fear.
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A shining turnaround?It looks like the market may be falling for the next six to eight months. Even gold, a traditional haven, is taking a licking. But gold will likely come back before stocks do, says MSN Money's Jim Jubak -- because buyers will return to the jewelry market as prices drop.
For all these reasons, we're going to see an official bear in 2008. But how bad will it be?
Not as bad as the March 2000 to October 2002 bear that gave the S&P 500 a 48% haircut. We're not looking at the kind of collapse in earnings and revenue that we saw then in the technology sector, and we didn't start with stocks trading at anywhere near those nosebleed valuations this time. John Murphy, a technician on StockCharts.com whose work I respect, was, as of Jan. 17, looking for a drop of at least 20% in the Dow from the October 2007 peak, a minimum 22% decline in the S&P 500 and a drop of at least 26% in the Nasdaq.
I believe the bear market loss this time will be more than what Murphy is forecasting but less than the drop in 2000-02. And I'd expect that the duration wouldn't be as long as the 30 months of 2000-02. Remember, fiscal and monetary stimuli take six months to work through the economy. On that calendar, the surprise interest-rate cut announced today or a stimulus package that goes into effect this month or next would start to lift the economy in August or September.
Continued: 5 rules for surviving
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