Our long term S&P 500 model states that the U.S. stock market is not in a bear market. We define “bear markets” as declines that exceed 33.33% and last more than 1 year.

Our medium term S&P 500 model has been predicting a significant S&P 500 correction since the end of March 2015. We define a significant correction as either a big correction or a long consolidation.

Neither a big correction nor a long consolidation has been completed as of October 1, 2015. Hence, we are waiting for a significant correction to be completed before we buy stocks.

We’ll cover the following topics in this post:

1. Is there something wrong with the U.S. economy?
2. The bearish argument.
3. The bullish argument.
4. The tech industry is not in a fully fledged bubble yet.

Is there something wrong with the U.S. economy?

It’s seems that there’s something wrong with the U.S. economy.

Cullen Roche from PragCap describes the current situation perfectly:

There has been so much conflicting data in recent weeks.  Housing data has been strong, jobless claims are near lows, ADP employment was strong, manufacturing is weak, auto sales were through the roof, the Challenger Job Cuts report showed labor deterioration, etc.  But this has been the story of the last 7 years.  It has been an uneven muddle through.   This economy remains very weak despite what some of the headline figures say.  And that’s one reason why I am so skeptical of a recession right now.  It’s hard to die when you’re jumping out of the ground floor window.

We agree that the odds of a recession are very low. Current economic problems are not significant enough to cause a bear market. However, they can cause a big correction like they did in 2011.

U.S. Economic Data is Deteriorating

There are 2 things to note when looking at economic data:

1. The actual figure vs previous months’ figures. Is growth accelerating or decelerating?
2. The actual figure vs expectations.

The U.S. economy was on fire in 2014. Actual figures beat previous months’ figures and expectations.

Then the actual figures started to miss expectations but beat previous months’ figures in the first half of 2015.

Then U.S. economic data deteriorated more in the summer. Actual figures began to miss both expectations and previous months’ figures.

Actual figures in September were missing expectations and previous months’ figures by shocking amounts. We can see this in the August and September jobs reports.

This Friday’s weak jobs report was merely a harbinger of larger problems in the U.S. economy. Employment data lags the real time state of the economy. With weak jobs reports in August and September, we can assume that the U.S. economy began to deteriorate many months ago.

It’s also important to not read too much into the jobs report.

According to Bill McBride from CalculatedRiskBlog

There is always some variability in the month-to-month employment reports, and my general reaction is R-E-L-A-X.  Jobs gains are still solid year-over-year, and I expected some slowdown in job gains this year – also recent gains are still large enough to push down the unemployment rate.

It seems increasingly likely that the Federal Reserve will not raise interest rates in 2015. We predicted this a few weeks ago. With the U.S. economy slowing down and the U.S. stock market on a weak footing, the odds of a rate hike are very low.

Mass Job Cuts

Large U.S. corporations are cutting more jobs than before.

“Job cuts have already surpassed last year’s total and are on track to end the year as the highest annual total since 2009, when nearly 1.3 million layoffs were announced at the tail-end of the recession,” said John A. Challenger, CEO of Challenger, Gray & Christmas.

Large scale job cuts on their own don’t mean much. Big companies lay off workers to trim costs all the time. However, mass job cuts that coincide with deteriorating economic data hint at something amiss in the economy.

1. HP is cutting 25,000-30,000 jobs.
2. Wal-Mart is laying off hundreds of workers at it’s headquarters. These are all managerial level jobs.
3. AMD is cutting 500 managerial level jobs
4. ConAgra is cutting 30% of it’s global office workforce.
5. Chesapeake Energy is trimming 15% of its headcount.
6. Whole Foods is laying off 1500 employees.

The Bearish Argument

Large U.S. investors are dumping stocks.

U.S. mutual funds suffered $63 billion in redemptions in Q3 2015. In terms of absolute dollar redemptions, this is among the largest in any 3 month period over the past 20 years. Redemption as a percentage of assets is more important. The three month outflow from July to September totals just under 0.8% of assets. That doesn’t seem like much, but it still ranks among the larger outflows over a three-month period.

What’s interesting is that only $17 billion of the $63 billion worth of redemptions occurred in August, the month when stocks crashed. This means that large institutional are still selling a lot of stocks right now, after the market crashed.

It’s important to note that large amounts of selling from institutional investors does not mean much on its own. Mass selling can occur near the bottoms of big corrections. It can also occur in the beginning of bear markets like it did in 2001 and 2008.

Our model states that a bear market is not at hand. However, we do not know if the current correction is over. Regardless, continued selling from institutional investors will be a bearish cloud over this market.

Over the past week, S&P 500 futures have often made highs during the night when volume was low. Nighttime market players tend to be day or swing traders. Then the market often fell in the morning when volume picked up. Does this mean that most of the buyers are day traders while sellers are large investors? Perhaps. If so, then this is bearish. Day traders cannot turn a big correction around on their own.

The Bullish Argument

Friday’s price action was bullish.

The jobs report was terrible on all accounts:

1. The 142,000 jobs added in September was significantly lower than previous months’ figures.
2. The September figure missed expectations by more than 25%.
3. Wages remained stagnant.
4. The previous 2 months’ figures (July and August) were revised down.

What’s interesting is the market’s response to this “bearish” event.

Click on picture to enlarge

The S&P gapped down on the weak jobs report by 15 points and continued to fall until it reached the 1897-1900 support level. The fact that this support level held was bullish enough. On top of that, the S&P completely reversed the decline and ended the day up 1.43%.

A market that acts positively to bad news is bullish.

The Tech Industry is Not in a Bubble Yet

There are now 138 “unicorn” companies in the world with a combined valuation of $501 billion. (A “unicorn” is a startup that’s valued at more than $1 billion.) The mind boggling number of unicorns has many investors screaming “tech bubble!”. On the contrary, we believe that the tech industry is not in a fully fledged bubble yet. The industry still has a few years to go before it’s in a fully fledged bubble.

There Will Be Multiple Booms and Busts Before the Bubble is Over

Investors forget that there was no single “internet bubble” in the 1990s. Rather, the bubble came in multiple waves along with multiple busts.

1. There was a record $60 billion worth of IPO’s in 1993. That was 7 years before the bubble ended.
2. Internet stocks were insanely hot by 1996. The bubble still had 4 years left.
3. Major search engines Lycos, Excite, and Yahoo announced plans to go public in 1996. Lycos and Excite had low revenues and no profits but went public in April 1996 for hundreds of millions of dollars.
4. The bubble’s first mini-bust occurred in mid-1996. The stock market fell that summer and Internet stocks tumbled. The market’s downturn also hit other Internet companies that were planning to go public. Excite, AOL, and Lycos stocks had been cut in half by the autumn of 1996 while Yahoo had fallen more than 1/3. The IPO market was virtually closed.
5. The internet bubble began to reflate again in 1997 with a new wave of IPO’s. Amazon.com was the hottest IPO of the year.
6. The big correction of 1998 almost brought the party to a screeching halt. Internet stocks were hit particularly hard in August 1998. Excite and Amazon both fell by more than 20% while Yahoo and AOL fell by 15%
7. The stock market and internet stocks fully recovered by the end of 1998. A new wave of IPO’s ensued, including eBay and theglobe.com.
8. The bubble deflated for the last time by the beginning of 2000.

As you can see, there were multiple booms and busts in the 1990s internet bubble. Thusfar we have only had one bust.

1. Many companies that were part of the first wave of IPO’s in 2012 have sunk. Zynga, Groupon, Demand Media, and other once-hot tech companies have seen their stock prices crater.
2. Perhaps we are about to experience the 2nd mini-bust in this budding tech bubble. Many tech startups are spending money twice as fast as revenues are coming in. This means that if the capital markets dry up or even slow down, a lot startups will run out of cash and run aground.

The first round of the dying unicorns are coming in.

1. Evernote, the note taking company
2. Jawbone, the fitness tracking company
3. Zirtual (already gone_
4. Gilte Groupe, the online shopping company