The two phases of the bear market (Madame Guillotine strikes)

Guillotine strikes

If you’ve been following our 8 timeless principles of investing carefully then you’ve successfully avoided the initial market crunch we’ve been warning about throughout the duration of this blog.

This has been the fastest moving bear market in history for the US.

The Aussie market also recorded a 32% decline in stock valuations across 3 weeks, before snapping back sharply from its alarming losing streak during Friday’s trade.

Although this brutal guillotine strike acted as an initial shock to sentiment market valuations are still far too high.

Investors must now remain extremely wary of the key risk during the next phase of the cycle: being sandpapered to death.

Two phases of bear markets

Although history doesn’t repeat, through the cycles investor sentiment does tend to rhyme.

Here are the two phases of the bear market:

Phase one, the guillotine, has already been initiated over the past three weeks.

There then tends to follow a flicker of optimism that perhaps things mightn’t be too bad, or that hopefully markets might immediately return to normal in an orderly fashion.

But the spell has been broken, and in time phase two will follow: the sandpaper.

Whipsaw rallies

On Friday, as we anticipated and discussed here, on Friday came the first dramatic rally of the bear market.

This is normal and to be expected, and it’s what we always see in bear markets.

The sheer size of the intraday swing in Australia was unprecedented.

That shouldn’t be a surprise, since markets can reflect a certain symmetry, with short sellers covering, fund managers desperately looking for opportunities to buy in after a 32% drop, algorithms being triggered, and so on.

The fastest moving bear market we’ve experienced may well contain some of the most dramatic daily rebounds.

However, be warned, because the downtrend in investor sentiment remains firmly intact.

Bull trap sprung

Friday’s rally inevitably leads on to permabulls and optimists calling for a possible market bottom and discussing the potential for great buying opportunities.

Realistically it’s normally the same people that were also recommending buying before the crunch, so it’s not a meaningful guide from a market timing perspective.

Unfortunately, on the balance of probabilities, they’re likely to be wrong.

As we previously discussed here, volatility is a key characteristic of bear markets, with 5% daily gains featuring regularly during the tech wreck and the global financial crisis.

To elaborate further on this point, a higher level of market volatility has historically had a proven link with lower expected returns:

The current level of volatility is unprecedented in modern times, with stocks moving between 4% and 10% on every day of the past week for the first time since the Great Depression.

The market was also trading limit down one day and limit up the next, for the first time ever (the SPX will probably hit limit down early in Monday’s trade too).

These are wild and unrivalled moves, and unfortunately they do not signal a market at its bottom.

Earnings decline

Moreover, the cumulative and deleterious effects of the coronavirus have not yet even begun to be felt on the economy, let alone reflected in company earnings.

Cases have increased from 100,000 to 150,000 over the past 8 days, suggesting that countries across Europe such as France, Spain, and possibly Germany will first go into lockdown, with others to follow.

We have no reason or desire to be alarmist but should the spread of cases seen in other countries be seen in Australia, then schools and universities will be closed for a time, international travel banned, and non-essential businesses may be impacted.

The initial effects will be felt most keenly over the coming few weeks by airlines, cruise ship operators, travel agencies, hotels, and tourism resorts, among others.

But eventually the erosion of revenue and earnings will likely spread into retail and wholesale trade, construction and the trades, banks, insurance groups, other financials, and other business services.

Oil prices touching two-decade lows will also cripple the value of LNG exports, global capital investment in the energy sector, and on and on it goes.

Critically, US stocks are still trading at very frothy valuations, even after the initial guillotine phase, and this chart is before company earnings are punched lower.

The US CAPE ratio has fallen from above 33 to about 26, but in a now-likely recession scenario there’s no reason it can’t fall towards 15 (or even towards 10).

In summary the initial guillotine phase has now been initiated on stock market sentiment.

Be wary of being sandpapered to death.

Published by petewargent

CEO Next Level Wealth, & AllenWargent Property Buyers, with offices in Sydney, Brisbane, & London. Leading Australian market analyst, & 6-time published finance author. For more see: Qualifications including: B.A. (Hons.) Industrial History, Chartered Accountant (FCA), Diploma Financial Services (Financial Planning), Chartered Secretary, Advanced Diploma Applied Corporate Governance.

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