Here's What March Told Us About the Coming Bear Market

You've seen this in cheesy Western movies: an armed standoff that often begins with some variation of "This town ain't big enough for the both of us."

That's where we are now with stocks and bonds. And we're rapidly approaching the point where the town ain't big enough for either of them.

The U.S. Treasury continues to pound the market with massive amounts of new supply, but Treasuries held their own this month and even rallied a bit.

Instead, stocks caught it in the neck.

So what's happening? Nothing good...

It's a simple question of liquidity, or, more specifically, the lack of it.

As I've been telling my Sure Money readers, there's no longer enough liquidity in the system to support bullish moves in both stocks and bonds.

If one rallies, the other must be the source of funds for that rally. So in March, stocks were the liquidity sink that supported the rally in bonds.

And don't be fooled by events like we saw this past Thursday, when there were rallies in both stocks and bonds: Neither baseball, nor life, nor markets move in a straight line. They are full of surprises.

But those surprises happen in the context of a broad arc. And right now, that arc is pointing down.

The rapidly deteriorating momentum in stocks and bonds tells us a lot about the bear market I see around the corner.

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Here's the Sinister Truth Behind the Recent "Bonds Up, Stocks Down" Action

What we're staring dead in the face now is what I've been predicting since mid-January, when I said, "Within a few months, I expect that stocks will also succumb to a growing shortage of cash as the Fed pulls money out of the system and the Treasury pounds the market with immense amounts of new supply."

I've also noted in the past that dealers and speculators seem to have funded their stock speculation by increasing the type of short-term borrowing that normally finances their bond purchases.

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They have instead shifted the cash from that borrowing to stocks. This is nothing less than borrowing from tomorrow for speculative profit today.

Again, in January, I said, "This first quarter of 2018 should be the turning point. We are facing be the worst liquidity conditions that we have seen since the 2008 collapse, and those conditions will only tighten more through the year..."

Then, we got the stock market "correction," which was a crash in all but name, back in early February. Bonds had been selling off starting from mid-December.

So of course, bonds rallied when stocks crashed in early February, right? Right?

Wrong. There was nothing - no rally in bonds at all. When dealers and other market participants liquidated stocks in early February, they did not use the cash to buy bonds.

In fact, after stocks bottomed and began a spirited rally on Feb. 9, the selling in bonds continued. If anything, we saw rotation out of bonds and into stocks. The bond sell-off continued until Feb. 21.

The stock rally had twin peaks at the end of February and on March 12. Bonds rallied modestly beginning on Feb. 21. That rally picked up a little steam last week.

As stocks were sold off from March 13 to March 28, some of the cash from that liquidation was used to buy bonds, contributing to that bond market rally.

That's portfolio rotation, folks. And it's not positive rotation; it's alternating waves of liquidation.

So there's no longer sufficient liquidity to support concurrent bull moves. The town isn't big enough for two gunfighters. And I forecast that initially we'll see rotating waves of liquidation in stocks and bonds.

I expect more of this rotational liquidation in the months ahead. As the Treasury continues to bury the market with supply month in and month out, and the Fed pulls more and more money out of the system, the time will probably come when both stocks and bonds sink together.

The town will get so small, the gunslingers will just leave. That's no fun at all.

Here's what I suggest we do about it...

What to Do When the "Classic" April-May Rally Fails

I'm sticking to my recommendation to be 60% to 70% in cash (more or less, depending on your circumstances).

When I first suggested taking such a position back in September 2017, I said that it should be done gradually and systematically, selling a small amount each month as the market rallied, with the goal of reaching that cash level by the end of January.

As time went on, I said that if you hadn't gotten there yet, again do so in increments by the end of March.

Then, for late arrivers, I wrote that the goal should be to have that cash position in place by May. That's because the market usually has a rally from around mid-April to late May.

Why? Well, it's simple: The Treasury takes in so much cash on April 15, "Income Tax Day," that it pays down some debt. That puts billions in cash back into the accounts of the dealers and investors who had been holding the paper that was paid off.

Those temporary paydowns provide the fuel that usually triggers a rally. However, this year the paydowns will be smaller than usual.

In their infinite wisdom, Congress and the Trump administration have massively increased the deficit via the "Trump tax cuts" and the spending deal. No two ways about it: These deficits must be covered by selling new debt.

In March alone, that totaled a mindbending $271 billion in net new issuance.

You guessed it: Those debt sales will pull massive amounts of cash out of the market month after month.

Somebody has to pay for that. Under QE, it was the Fed. But that game ended in 2014, and now the Fed is actually stabbing investors in the back by pulling money out of the system just when the Treasury is making these freakishly huge demands on it.

So here's the thing about those big paydowns that come every year from mid-April to mid-May. This year, those paydowns won't amount to very much - relatively speaking, "only" around $16 billion - if the Treasury Borrowing Advisory Committee's (TBAC) guess is close.

Yes, that should be enough to give the market a respite from the onslaught of Treasury supply. But it's hardly sufficient to fund a big rally in either stocks or bonds.

Remember, in April the Fed starts pulling $30 billion per month out of the banking system and the markets, up from $20 billion now. The short-term Treasury paydown won't come close to making up for that.

So don't hesitate to continue raising cash. Whereas before I said to sell into rallies, now I'd be reticent to wait for a rally. The next breakdown that takes out the February lows could trigger a dramatic sell-off. If that occurs, it would confirm a bear market, and there would be no reason to be heavy in stocks.

Make no mistake: Fed policy is now, and will continue to be, hostile to the markets for many months to come. The Fed has set a schedule to reduce the size of its balance sheet and get to a "normalized" reserve position. That will last well into the year 2020, unless the market and the economy force the Fed's hand to reverse course. That will certainly happen at some point. But by that time, the damage will be done.

This will not be a flash-in-the-pan, six-month, "20% down" bear market. Oh no.

Rather, it will be a more typical 18 to 30 month affair that will take stock prices much lower. When a bear market is confirmed, I would use the next rally to raise cash to the 80% to 100% level. There will be ample opportunity to get back in at much lower prices later.

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About the Author

Financial Analyst, 50-year charting expert, finance + real estate pro, and market analyst; published and edited the Wall Street Examiner since 2000.

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