8 Signs of a Bear Market

You can't time the market, but you should know what might cause share prices to fall again.

By Chana R. Schoenberger, special to Kiplinger.com

The remarkable stock-market recovery that began nearly a year ago may be petering out. Although the leading market indexes continued to set new recovery highs through mid January, today they are only about 2% above where they stood nearly five months ago. “The momentum has begun to wane,” says Jeffrey Hirsch, editor of the Stock Trader’s Almanac.

The wall of worry that bull markets traditionally climb may have grown tall enough to discourage even the most optimistic of investors. Recent government reports show that gross domestic product in the U.S. grew a solid 5.9% in the fourth quarter of 2009, but many fear that the economy, particularly the housing market, is fragile. The jobless rate remains stubbornly high, and soaring U.S. budget deficits are a growing concern. Moreover, investors worry that sagging economies in Greece, Spain and other European nations could have ripple effects around the globe.

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U.S. stocks remain well above their March 9, 2009, low. Standard & Poor’s 500-stock index, which closed March 2 at 1118.31, is up 65% since then and is just 2.8% below its January 19 recovery high. The market still hasn’t experienced a correction -- defined as a drop of at least 10% -- since beginning its recovery.

The big question now is whether the bull market is merely resting or is about to give way to a new bear market. We don’t think most people can time the market consistently well enough to make it worth trying to do so, but it is important to look at what might cause share prices to tumble. In that spirit, we look at eight areas that could presage the next bear market.

1. Weakening economic indicators. Analysts are nearly unanimous in their view that the strong growth in the fourth quarter is not sustainable. What’s less clear is whether the economy will grow moderately, minimally or return to recession. At any rate, poor results for indicators such as consumer confidence, payroll and manufacturing can be early warning signs of trouble ahead. “If we start to get a lot of disappointments on the economy, or if car sales are weaker than expected, analysts will respond pretty quickly by lowering their expectations,” says Ed Yardeni, president and chief investment strategist of Yardeni Research, of Great Neck, N.Y. (see What Could Derail the Recovery).

2. Deteriorating corporate earnings. Stock prices are based on investors’ views about future corporate profits. When investors expect profits to shrink, stock prices usually go down. Many companies were able to generate profit growth or minimize recession-induced declines the past couple of years by reducing head count and otherwise cutting costs, says David Joy, chief market strategist at RiverSource Investments, in Minneapolis. But “that’s a strategy that will only take you so far,” he says. If revenues don’t start to improve soon, companies may find it difficult to meet investors’ earnings expectations, and that could lead to sinking share prices.

3. Continued troubles in housing. The collapse of housing prices and the resulting impact on mortgage-related security played a leading role in the financial crisis and the Great Recession. The housing drama isn’t over yet, as recent declines in sales of both new and existing homes indicate. “We’re not really out of the woods yet in the housing market,” says Yardeni, who predicts many more foreclosures ahead. A slow recovery in housing will affect builders and companies that sell construction materials, as well as banks that will bear the brunt of mortgage defaults. Shaky loans will also spill over into credit cards as borrowers shift their debt to other forms of lending. All of this could spell trouble for the stock market.

4. The inevitable return of inflation. With so much slackness in the economy, consumer prices aren’t rising much nowadays. But superlow interest rates and other federal stimulus measures could be the match that ignites inflation down the road. “The government is doing some very inflationary things, and inflation always drives a down market,” says Howard Ruff, publisher of Ruff Times, an investment newsletter. With Uncle Sam running his printing presses overtime to create more money, inflation will rear its head by year’s end, says Ruff.

5. Geopolitical grimness. Political and military instability can always push a market over the edge. Investors have grown accustomed to U.S. involvement in the ongoing wars in Iraq and Afghanistan. But there are simmering threats from Iran and North Korea, as well as concerns about the stability of Pakistan. And terrorism by Al Qaeda and other groups remains a constant threat. “Terrorism is something we will always have to worry about,” Yardeni says.

6. Political shenanigans. If history is any guide, the grandstanding leading up to the midterm Congressional elections will lead to exorbitant promises that will only add to investor uncertainty. “Midterm years are very prone to selloffs,” says Hirsch. On top of that, the contentious debate over health-care reform simply won’t go away. If Congress enacts a costly health-care bill, investors will grow even more skittish about future budget deficits.

7. Bear in a China shop. The recession barely touched China. Its economy grew 8.7% in 2009, and it’s expected to expand by 9.0% this year. But China’s leaders are getting worried that an overheating economy could stoke inflation. Beijing has already raised reserve requirements for banks and ordered lending to be dialed back, with a goal of trying to make sure that economic growth stays within a range of 8% to 10%. But what’s good for China could be bad for investors. Because companies worldwide are dependent on both Chinese production and, increasingly, Chinese consumption, global stock markets, including the U.S. market, could tank if China’s growth slows too much. “If China slows, the rest of the world will slow,” says Joy.

8. PIIGS in a poke. Overstretched homeowners falling into foreclosure made their own dismal contributions to the Great Recession and the attendant bear market. Now economists are worried that entire countries could default on their debts. The European Union is scrambling to rescue Greece from falling further behind on its debts and risking expulsion from the euro zone. “Greece could very well be the tip of the iceberg,” Yardeni says. Other European countries, notably Portugal, Ireland, Italy, and Spain -- together, with Greece, known as the PIIGS -- are also sparking concern for their large debt burdens. A wave of government defaults could scare investors into a bear market.