earnings season

Here's How Low the S&P 500 Could Go in This Bear Market

The bear market deepened last week as investors sold everything that wasn't tied down that had the faintest tinge of risk associated with it - stocks, commodities, junk bonds, you name it.

The Dow Jones Industrial Average lost 358 points, or 2.2%, to close below 16,000 at 15,988.08, while the S&P 500 fell 42 points, or 2.17%, to close under 1,900 at 1,880.33.

But losses could get even steeper from here...

Nasdaq's FANGs Faltered This Week

The Nasdaq Composite Index dropped 3.3% to 4488.42 as the so-called FANGs - Facebook Inc. (Nasdaq: FB), Amazon.com Inc. (Nasdaq: AMZN), Netflix Inc. (Nasdaq: NFLX), and Alphabet Inc. (formerly Google Inc.) (Nasdaq: GOOG) - all got de-FANGed, with Amazon losing another 6.1% on the week to fall to $570.18, more than 100 points lower than it started the year; Google/Alphabet dropping 2.8% to 694.45, down nearly 80 points year to date; Netflix down 6.6% to $104.04 on the week and 9% on the year; and Facebook down 2.4% on the week to $94.97 and down 9.4% year to date.

Rather than drag up the rest of the market, the FANGs are being pulled back to reality by the bear market that now has most of the stocks in the S&P 500 trading 20% or more below their 52-week highs.

Readers keep asking why I believe we are in a bear market. The reasons are simple: China is a house of cards whose debt-engorged economy hit a wall in mid-2014 after seeing its total debt grow from $7 trillion in 2007 to $28 trillion (it is now probably over $30 trillion). This then caused global commodities markets, which were inflated by the Chinese debt explosion, to collapse.

The last piece of the puzzle was the end of the Federal Reserve's quantitative easing (QE) program in October 2014 and the beginning of its effort to raise interest rates in 2015, though this didn't occur until last December and is more likely than not to be reversed in 2016 if markets continue to sell-off and the U.S. economy continues to weaken.

After ZIRP, Bear Markets Behave Differently

Many observers argue that we can't have a bear market unless the U.S. economy enters a recession or the Fed begins to aggressively tighten interest rates. I've been writing for more than a year in The Credit Strategist that this thesis needs to be questioned when interest rates are at zero as they have been for the last seven years.

I think the markets answered that question last year by rejecting that thesis - we entered a bear market in 2015 as most stocks in the S&P 500 fell by at least 20% from their 52-week highs.

Only the capitalization-weighted headline index failed to fall that much due to the performance of the FANGs and a select group of other stocks, like Walt Disney Co. (NYSE: DIS), Microsoft Corp. (Nasdaq: MSFT), and Starbucks Corp. (Nasdaq: SBUX). With those stocks starting to falter badly, however, the index is quickly joining the rest of the crowd.

Another indicator that a bear market is upon us is the horrendous performance of credit markets.

The high-yield bond market fell apart in 2015 and got worse in January. The average yield and spread on the Barclays High Yield Bond Index is now 9.22% and 722 basis points, respectively, a jump of 0.48% and 62 basis points since the beginning of the year.

Not Just Trouble, but Bad Trouble

The sectors that led the way down, energy and basic industry, are in deep distress. The average yield and spread on the energy sector is 17.26% and 1,444 basis points, respectively, while the average yield and spread on the basic industry sector is 14.01% and 1,172 basis points, respectively.

Investment grade spreads have also blown out to 167 basis points from 120 basis points a year ago. It has become much more expensive for Corporate America to borrow, which means that the days of borrowing endless amounts of money to buy back endless amounts of stock are over.

In view of the fact that stock buybacks and quantitative easing (QE) were the two props holding up stock prices, the markets are likely heading lower - likely much lower.

Treasuries acted as a safe haven as the stock market fell apart last week. The yield on the 10-year Treasury dropped to 2.03%, and the yield curve moved to its flattest level since 2009.

A flat yield curve indicates a slowing economy. Treasury yields would likely be lower but for the fact that China has been selling part of its huge reserves in order to bolster its markets, which have dropped more than 20% from their 52-week highs and have clearly embraced the bear.

China is in serious trouble with little sign that conditions will improve anytime soon.

The question is whether China and its commodities bubble will take down the world like the United States and its housing bubble did in 2008. Nobody can answer that question with certainty, but we do know that there is more debt and more geopolitical instability today.

On the flip side, U.S. banks are much better capitalized and in a much better position to handle a global sell-off. For the moment, the most likely scenario is that markets continue to sell off but that we experience something less severe than 2008. But that could still mean large losses for investors.

I am lowering my 2016 S&P 500 forecast from 1,875 to 1,900 to 1,650 to 1,750, which means that I expect the market to hit those levels sometime in 2016. Investors should reduce or eliminate their equity exposure and wait for better days.

There is no reason to sit and try to pick up nickels in front of a steamroller.

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