Since we published our 2015 market outlook at the end of 2014, we’ve warned of the potential for a bear market to emerge in the final months of 2015 or early 2016. This forecast rests primarily on these technical indicators that continue to raise red flags.
A healthy market rally involves stocks from a wide range of industry groups, including large-capitalization names that figure prominently in the S&P 500 and the small fry tracked in the Russell 2000 Index.
However, market leadership tends to narrow in the lead-up to a bear market. Let’s look at the technical indicators on four recent occasions where the S&P 500 gave up more than 20 percent of its value from peak to trough.
This relatively short-lived bear market included the infamous Black Monday, a horrific selloff that occurred on Oct. 19, 1987, and wiped out 22.62 percent of the Dow Jones Industrial Average’s value in a single trading session.
From the S&P 500’s intraday high on Aug. 25, 1987, to its intraday low the day after Black Monday, the benchmark index gave up 35.94 percent of its value.
The 1987 bear market stands out for its brevity and severity relative to the S&P 500’s typical post-1960 pullback—and the fact that the selloff wasn’t accompanied by a US recession. At the time, the US found itself in the midst of a powerful economic expansion that began in November 1982 and didn’t end until July 1990.
Bear markets that have occurred without a US recession have swiped an average of 24.2 percent from the S&P 500, compared to 38.3 percent when these pullbacks coincide with a major economic contraction.
In 1987, the S&P 500 surged 39.1 percent through its peak in late August. But signs of trouble lurked beneath the surface during this rally.
Although the S&P 500 rallied to new highs between mid-1986 and August 1987, small-cap stocks lagged the broader equity market over this period. In the 12 months prior to the start of the 1987 bear market, the Russell 2000 Index gained 22.2 percent, compared with the S&P 500’s 35.9 percent gain.
This divergent performance suggests that a relatively small group of large-capitalization stocks drove much of the early 1987 rally in US equities.
The bear market that started in July 1990 roughly coincided with the economy slipping into a mild recession that lasted into March 1991.
Without posting meaningful gains, the S&P 500 reached a series of new highs between mid-1989 and July 1990. As in the 1987 cycle, the Russell 2000 underperformed the S&P 500 markedly about a year before the broader market peaked in July 1990. This time, the Russell 2000 hit its top in October 1989 and traded steadily lower in absolute terms, while the S&P 500 ticked up to new highs.
Between July 20, 1989, and July 20, 1990, the S&P 500 gained about 12.1 percent; the Russell 2000, in contrast, gave up 4.1 percent of its value.
The S&P 500 tumbled by 50.5 percent during the technology bust of 2000, and the Nasdaq Composite Index plummeted by almost 80 percent. Meanwhile, the US economy endured one its mildest and shortest postwar recessions in 2001.
When the market collapsed in 2000, the small-cap stocks in the Russell 2000 had lagged the S&P 500 for about six years. This underperformance intensified in 1998 and early 1999, roughly a year before the S&P 500 peaked in March 2000.
During the final years of the late 1990s bull market, technology stocks led the market higher, while equities leveraged to the so-called old economy languished.
The S&P 500 Industrial Index, for example, rallied 6 percent between March 1, 1999, and March 1, 2000—a period when the S&P 500 gained 13 percent, fueled by upside in technology stocks. And the tech-heavy Nasdaq Composite Index fared even better, soaring 109 percent over this 12-month period.
Market leadership also narrowed considerably in the late 1990s. In October 1997, more than 600 equities traded on the New York Stock Exchange (NYSE) hit new 52-week highs.
Fast-forward to early 1998, when the S&P 500 rallied to new highs, climbing about 24 percent from its January 1998 low to its peak in April 1998. But less than 400 NYSE-listed stocks reached new 52-week highs during this rally.
By the first quarter of 2000, less than 150 NYSE-listed stocks rallied to new 52-week highs on any given trading session. Ironically, as the selloff in the Nasdaq Composite Index gathered steam, the number of NYSE-traded stocks hitting 52-week highs actually increased. Investors may recall that in the early 2000s, small- and mid-cap stocks and select sectors fared reasonably well. Tech stocks, on the other hand, got mauled.
The S&P 500’s 57.7 percent decline between late 2007 and early 2009 occurred during the worst bear market for US equities since the 1930s and coincided with the most severe recession since at least the early 1970s and, arguably, since the Great Depression.
A lengthy period when small-caps outperformed ended in April 2006, with the Russell 2000 Index lagging the S&P 500 through early 2008—an early indication that the bull market had started to flag.
The S&P 500 reached a record high in October 2007, exceeding its previous peak by 1.5 percent. However, the Russell 2000 Index failed to hit a new high that month—a divergence that also served as a precursor to the vicious 2007-09 bear market.
Over the past 18 months, the Russell 2000 Index has lagged the S&P 500, gaining 7.6 percent compared with the latter’s 16.7 percent return. The S&P 500 also hit an all-time high of 2,134.72 on May 20, 2015, while the small-cap benchmark managed to achieve a new record at the end of June.
Other indicators of market leadership suggest that bear market could be emerging from hibernation in early 2016.
In May and June 2015, no more than 171 NYSE-listed stocks logged new 52-week highs on any given trading day—down from more than 300 in the second half of 2014. This key divergence has preceded all the major market tops highlighted in this article.
Our near-term market outlook calls for the S&P 500 to rally over the next one to three months, retesting its May 2015 top or ascending to a new peak that’s incrementally higher. We also expect the Russell 2000 Index’s next rally to fall short of its late June peak and for the number of stocks participating in this upside to narrow considerably.
The last-gasp rally of this aging bull market will set the stage for a correction of at least 20 percent in the first half of 2016. This outlook is based primarily on technical indicators.
In coming weeks, we’ll examine the latest readings from some of our favorite indicators as we take the US economy’s temperature. We don’t foresee an impending recession at this juncture, though some cracks have started to emerge.
If the US avoids a recession, the looming bear market should be relatively short-lived and lack the bite of some of its predecessors. We’ll continue to monitor the economic situation to determine whether investors need to prepare for a more severe decline.