5 Signs That a Bear Market Is Coming

With the S&P 500 sitting at an all-time high, it’s hard for many people to believe that a bear market could be coming.  A correction of 5 percent? Sure! But a bear market — loosely defined as a 20 percent fall in stocks or more — seems to be out of the question.

However it is precisely during these periods when the market is most vulnerable — practically everybody who follows the market is bullish,  and investors own stocks without hedges, and this means that there is simply no one left to turn bullish and buy. While such situations can last for long periods of time, there is a possibility that we could be very close to a bear market. Here are five reasons why.

Source: Thinkstock

1. Stocks are historically overvalued

The S&P 500 — as measured by the iShares S&P 500 Index Fund “IVV” — currently trades at over 22-times earnings and with a dividend yield of just 1.85 percent. Historically the average P/E ratio is closer to 12-15-times earnings and with a dividend yield of 4 to 5 percent.  But this is just the “average.” When stocks correct, they go from being overvalued to undervalued. Historically stocks have bottomed with a P/E ratio of less than 10 and with a dividend yield of 6 to 8 percent.

We have seen stocks reach these levels or even lower at major market lows such as in 1932 and in the early 1980s. This value-level is so alien to modern investors that the majority of investors believe that the 2009 low was “the low.” But in fact we only hit the historical average valuation level in 2009, and ultimately I think that stocks can potentially sink lower.

2. The copper price is breaking down

As I wrote recently, investors need to watch the copper price. Copper can be a leading economic indicator because it is so ubiquitous in industrial and consumer goods. If the copper price falls this could be the result of lower demand, which results from lower demand for the goods that contain copper. Since I wrote about it, we had yet another big down move in the copper price, and now it is trading at less than $3 per pound, its lowest level since 2010. While commodity prices can move for all sorts of reasons, there is a good possibility that the copper price is falling because demand is falling, and this could signify the beginning of a recession and a bear market in stocks.

3. Chinese exports are plunging

According to Reuters, China’s exports collapsed by 18 percent in February. While this certainly hurts China’s economy, it also suggests that China’s largest trading partners are suffering economically, as it means that they are importing less unless they are importing more from another source.  For the United States this is highly unlikely, as the United State’s largest trading partner is China, and the United States is China’s second largest trading partner behind the European Union. Lower demand for Chinese goods almost certainly implies that consumption in the United States is falling, indicating an economic slowdown.

4. American retailers are not performing so well

Bellwether retailers in the United States such as Wal-Mart are reporting lower profits and sluggish sales. Even companies that have stocks that are performing very well and that have bullish sentiment are seeing fundamental weakness, such as Home Depot (NYSE:HD). In fact Home Depot trades at 21.6 times earnings despite the fact that it has declining sales and analysts have a “buy” rating on it along with an $89 price target (the shares trade at $81 each). When companies as large as Wal-Mart and Home Depot are seeing weakness this almost certainly reflects a broader trend. The implication here is that the U. S. consumer is weak, and this weakness could cause, or be symptomatic of, an economic slowdown.

5. Analysts are just too bullish

What I said above about Home Depot is a perfect example of this. I find it very difficult to pay 21.6-times earnings for a company that is seeing its sales decline year over year, and yet analysts believe that the stock should be trading 10 percent higher. We find extreme optimism from analysts who cover other companies as well. Chipotle Mexican Grill (NYSE:CMG) is a good example of this. The shares trade at over 40-times this year’s earnings expectations and yet analysts still like the stock. Meanwhile the company is going to be facing headwinds such as the weak consumer and rising agricultural commodity prices. When we have a market in which analysts make excuses for historically extreme valuations, it is generally a sign that a bear market is coming.

With these points in mind, investors need to be very careful. If you must own stocks, find companies that are trading at reasonable valuations with strong businesses that are growing. But also consider hedging these positions by owning put options on the SPDR S&P 500 ETF (SPY), or by owning some Treasuries and some gold. While we can’t be certain that a bear market is coming there are numerous signs that demand investor caution.

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