The coming bear markets in stocks

Unlike bull markets, which require time for investors to climb walls of worry on each up-leg, bear markets typically play out faster to the downside. The bear market of 2010-2011 should be no different. We feel this way for the following ten reasons.

The underlying thesis for our bearishness is quite simple: with debt issues metastasizing in Europe, discontent with Washington’s ineffectiveness growing by the day, and consumer confidence plunging to 30-year lows, the valuations that investors are willing to place on risky assets, i.e. stocks, have moved lower. While certainly the cheapest in years, the market’s current P/E of 12 is not cheap enough to mark an ultimate bear market bottom. Eventually the market’s P/E will trend down into the single digits just as they do at the end of every secular bear market for equities. This process will require a few years, resulting in many fits and starts as investors fight this trend.

While it is true that we are oversold and extended to the downside (the S&P 500 could very easily bounce back above 1,200 and move toward 1,225-1,250 in the next few weeks), this bounce will fail. Even with the recent slide in stocks, professional investor sentiment remains overly bullish. Doug Kass, Laszlo Birinyi, and Abby Joseph Cohen (check out her revised 1,400 year-end target for the S&P 500 in this weekend’s edition of Barrons!) remain ardent bulls. With these pros and others buying into the “current correction”, in time, these investors will help fuel another down-leg when they change their bullish tune and recognize that they are wrong.

This is a global bear market. Brazil, China, and the European bourses are leading the U.S. lower. We expect this trend to continue. In the very near-term, Europe’s markets rallied after short-selling was banned in a number of countries. When the buying dries up and with no shorts to provide buying power on the way down, we feel that this removal of the shorts will backfire for Europe just as it did in the U.S. a few years ago. Here is what Jim Chanos had to say on this matter late last week: “EU policy makers don’t seem to understand the law of unintended consequences. The vast majority of short-selling financial shares is by other financial institutions, hedging their counterparty risks, not speculators. The interbank lending market froze up completely in October to December 2008 – after the short-selling bans.”

Do not expect a quick fix from Tuesday’s summit between Germany and France. This weekend, Germany rejected calls by Italian Finance Minister Tremonti for the creation of Euro-bonds which would effectively make individual governments’ debt a common burden. Germany’s Finance Minister Wolfgang Schaueble quickly rejected this plan in Der Spiegel: “I rule out euro bonds for as long as member states conduct their own financial policies, and we need differing interest rates so that there are possibilities of incentive and sanctions to force fiscal solidity.” Ultimately, Germany will have to make a choice to either backstop Italy and Spain or let them default on their debt. With many in Merkel’s inner circle recommending that she steer away from eventually rescuing Italy because such actions could put Germany’s own banking system in peril, we feel that Germany will ultimately let Italy go. Perhaps this is why interbank lending has begun to materially slow down in Europe and why Bridgewater Associates released the following short note on Thursday: “There is an uncomfortably high probability that there will be an unmanaged banking and sovereign-debt crisis in Europe.”

Listen to Bert Dohmen, the editor of The Wellington Letter. Bert has had a tremendous track record of forecasting recessions and bear markets. According to Bert, we entered a recession in May and profit forecasts for the second half of this year are too high and will be revised lower. In a recent interview on CNBC, Bert gave his market thoughts.

If one noted technician’s bearish call was not enough, take note of another’s: Stan Weinstein, who many consider one of the all-time greats of technical analysis, gave a bear market alert to his subscribers when all of the major indexes broke below their 200-day Simple Moving Averages in early August. According to Stan, there has been inordinate damage done to the market’s underlying technical structure. Having just moved into what Stan labels as stage 4, or the declining phase, this bear market has just begun and will need time to run its course.

China’s economy is slowing down rapidly. At some point, investors will turn their attention here. When they do, they will not like what they see. Just look at some recent stats on China’s economy: China’s bank lending slowed down rather sharply in July to a 7-month low; China’s money supply growth recently fell to a 6-year low; China’s July auto sales were extremely weak. While they rose 6.7 percent in July, the rise was well below expectations and the growth seen last year. Could these economic numbers explain why Brazil’s stock market is one of the worst in the world this year and why the materials ETF, Materials Select Sector SPDR ETF (XLB), plunged 16% from its early August highs?

Small-caps are leading the way lower in the U.S. While so many market pundits continue to try to buy the dip and call a bottom for stocks in various interviews the past 72 hours, not one of them has made mention of how small-caps have already moved into bear-market territory. Just as small-caps lead the bull market on the way up, they are leading on the way down. This is a very bearish sign.

The consumer is about to retrench in a meaningful way. Those bullish surely looked at July’s retail sales as a cause for celebration. However, these shoppers were gleefully shopping before their stock accounts plunged this month. Perhaps we should therefore give more attention to Friday’s plunge in consumer confidence to 30-year lows! With the consumer 70% of our economy, a move upwards in the savings rate to 7-8% will ultimately translate into much slower growth for the economy. Slower growth means lowered earnings expectations for Q3 and Q4 and for 2012. Lowered numbers leads to lower valuations and ultimately to lower prices for stocks.

The individual investor is done with stocks. Ordinarily, this would be a positive contrarian sign. Considering that mutual funds remain fully invested and at historical lows for cash levels, however, the fact that individual investors pulled $11 billion from stock mutual funds last week is quite troubling.

This trend seems destined to accelerate in the coming months, forcing mutual fund managers to sell more stocks to meet the calls for cash from their investors. Considering that tax-selling is just around the corner for professional and individual investors, this dearth of buying power will eventually force stock prices lower.

When we objectively take note of the aforementioned considerations, we remain quite bearish of stocks for at least the next 3-6 months. Because bear market rallies are sharp, vicious, and short-lived, we plan on patiently selling into this rally by going long the ProShares UltraShort Russell 2000 ETF (TWM), for the accounts we oversee. We remain buyers of the SPDR Gold Trust ETF (GLD) on pullbacks and have begun to slowly deploy money into select gold mining stocks with an eye toward their eventual break outs later this year/early next.

We also remain long two inflection point plays that most investors have never heard of before: Dynatronics (DYNT) and eGain Communicatiosn (EGAN.OB). With various catalysts approaching for both companies, including a potentially forthcoming lucrative and game-changing G.P.O. contract win for Dynatronics later this fall, we feel that both stocks will be much higher a year from now.

In conclusion, bear markets should not be feared as they will ultimately reward patient investors with bargain buys. Instead of being feared, bear markets should rather be respected. For us, that means understanding that now is the time for patience and discipline and not for aggressively buying into a bear market that is only three weeks old.