The Rushing Bear Market and How to Prepare

Oil prices plunged to their lowest prices in five years last week after the International Energy Agency (IEA) downgraded its forecast for global oil demand for the fifth time in six months.

The IEA report told markets that global growth will remain weak in 2015, triggering an across-the-board sell-off in stocks and junk bonds on Friday that left the major indices with some of their worst percentage losses in three years.

Unfortunately, stocks are still trading within a few percentage points of record highs reached only a week ago and remain severely overvalued in the context of seriously deteriorating economic fundamentals.

Investors that were complacently expecting stocks to melt up to "Dow 18,000" and "S&P 2,100" by year-end are now facing a the much grimmer reality of a correction and even the potential of a bear market in 2015.

By the Numbers

On the week, the Dow Jones Industrial Average plunged by 678 points or 3.8% to close at 17,280.82, its largest point and percentage drop since 2011. Only a week ago on December 5, the Dow hit a record closing high of 17,958.79.

The S&P 500 collapsed by 73 points or 3.5% to end the week at 2002.53 after closing a week earlier in December 5 at a record closing high of 2,075.37. The Nasdaq Composite Index fell by 127 points or 2.7% to end at 4653.6 and the small cap Russell 2000 dropped 29.99 points or 2.5% to end the week at 1,152.45. European stocks also got hammered and saw their biggest losses since 2011.

Falling Oil Prices are Taking Stocks With Them

Stocks followed oil lower. Crude futures fell $8.03 per barrel or 12.2% to $57.81, their lowest level since the depths of the financial crisis in 2009, down 46% from crude's 52-week closing high of $102.26 per barrel in June. More alarmingly, the price has completely fallen out of bed in the last three weeks, plunging by 24%. For the uninformed, which appears to include the entire financial media and most of the so-called experts who appear on their television shows, prices do not collapse that quickly due to oversupply; demand is melting away like a glacier in the summer sun because the global economy is deteriorating under the weight of too much debt and geopolitical problems. The question now is how quickly stocks will catch up to this inexorable reality and how widespread the damage will be.

Why This Flattening Yield Curve Signals a Gaining Bear

Anyone who questions the burgeoning economic weakness rearing its ugly head in the oil patch but about to spread far beyond North Dakota and South Texas and OPEC should pay careful attention to what is happening in the bond market. The U.S. Treasury curve flattened significantly this week, a phenomenon that has been occurring all year but is accelerating.

While moves in the yield curve are somewhat technical, they are extremely important for investors to understand because they establish the price of money in the economy. A flattening yield curve means that the difference in the price between short-term money and long-term money is diminishing which is a sign that lenders expect the economy to slow. On the shorter end, the 2/10 curve flattened by 21 basis points from 175 to 154 basis points last week and is down sharply from 261 basis points at the beginning of 2014. On the longer end, the 2/30 curve flattened by 13 basis points last week to 219 basis points and is down from 353 basis points at the beginning of the year.

Equally important, absolute yields are now moving down to levels that suggest that economic growth is slowing with the yield on the benchmark 10-year Treasury falling 21 basis points on the week to close at 2.1% and the yield the 30-year falling 22 basis points to close at 2.75%. Despite the fact that the U.S. economy has seen real growth (i.e. growth ex-inflation) of better than 3% during five of the last six quarters, these yields are signaling a coming slowdown.

We are taught that a bear market cannot begin until the yield curve inverts, but we are about to learn whether this rule-of-thumb still applies when interest rates have been pushed to the zero boundary by Federal Reserve policies that have distorted the value of all financial assets. Low interest rates are a sign of a weak economy. The fact that interest rates are so low suggests that something is amiss and should be flashing a warning sign to investors in stocks.

This month marks the sixth anniversary of the Fed's decision to drop the Federal Funds rate to 0-25% and keep it there long past the ostensible end of the financial crisis. What markets are going to find out - and what some of us have been warning all along - is that the crisis never ended but instead morphed from a fast-moving study in chaos theory and contagion to a slow moving event in which the Fed was praying for fiscal policy makers to come to their rescue with pro-growth policies.

Such policies are desperately needed to create sufficient productive capacity in the economy to generate enough income to service and repay the more than $100 trillion of debt that now exists in the world. Alas, no such miracle has occurred and the world is now left to figure out how to deal with this unsustainable debt burden. The options are both obvious and distressing (literally and psychologically). Fiat currencies will have to be further debauched and financial assets that have been inflated in value will now have the air let out of them. The only question is how quickly these adjustments will occur.

This Subtle Change in the Junk Bond Market Will Signal Real Distress

The drop in oil prices is just the first wave of deflation that will hit markets over the coming years. In addition to the deflationary signals being emitted by commodity prices led by oil, Japan and Europe are also exporting deflation through their central banks' easing policies. The world is experiencing a massive currency war and one of the currencies now in play is oil. Geopolitical pressures have added to world's tolerance for low oil prices or, phrased more bluntly, the Saudis are willing to bear the pain of lower oil prices to hurt Iran, ISIS and Russia and have the full backing of the U.S. and other Western nations to do so.

When $1 trillion and counting of money is removed from the global economy, which is what is happening with the price of oil effectively being cut in half, economic activity drops sharply and inflation morphs into deflation. Commodity prices and the yield curve are telling us that the U.S. is heading for both a growth scare and a recession. The question is whether an economy as leveraged as the United States is still capable of experiencing a mere recession or whether something much worse is in store.

The bloodbath that is unfolding in the energy sector of the high yield bond market could easily spread to the rest of that market, which has been trading at grossly overvalued levels for the last three years as investors have been duped into believing that five and six percent yields are sufficient compensation for owning what remain hybrid debt/equity instruments that pose a real risk of principal loss. The average yield on energy bonds has jumped to 9.42% from a record low 4.87% just six months ago (a level that should have told holders of these bonds to be selling). The average energy sector bond now trades at 87.7 cents on the dollar, a level that could easily move 10 or 20 points lower if contagion spreads.

Energy bonds approximately 15% of the junk bond market but oil itself has an impact on a much broader array of industries. The option-adjusted spread on the Barclays High Yield Index has widened out to 504 basis points but the average yield on the index is still only 6.83%, far below distressed levels. If current trends continue, spreads and yields could easily widen by another 300 basis points which would still leave them far shy of distressed levels.

Absolute yields will continue to be suppressed by lower benchmark Treasury rates so the telling sign that investors should look for is whether junk bond investors stop basing their valuations on spreads and start looking for absolute returns that accurately represent the risks they are taking.

When that happens, the market will truly be in crisis mode. Today's junk bond market is characterized by thin dealer inventories, a buyer's strike among distressed and event-driven sellers, and concentrated ownership among ETFs and large institutions which has led to a truly horrible liquidity picture. Despite the bold talk from Wall Street and some large investors like Blackstone and Oaktree, it won't take much more pain to send the market into a full-throated selling panic.

What Investors Should Do Now

What investors should be doing to prepare for them depends on their individual situations but at the very least they should be either significantly reducing or hedging their stock and junk bond exposures.

More aggressive and sophisticated investors can take steps to profit from the coming correction through options strategies and short selling strategies.

And everyone should be buying physical gold. What is happening is entirely a consequence of a failing monetary policy regime.

This may not be the end of that regime, but this is what the death rattles sound like.