Are we entering a bear market?

Historically the month of October is known for its volatility and so far it has not disappointed.  The explosion in volatility the first few weeks have coincided with a market correction.  A lot has happened in the last two weeks so lets get to the data.

The old saying, markets take the stairs up and elevator down certainly applies to the current pullback.  Months of gains have been evaporated in days as the speed of the downside move was violent.  However, so far the correction has been contained as the four big equity indices have losses ranging from 7 to 12%. 

Russell 2000   -12.4%
S&P                -7.8%
Nasdaq           -10.5%
Dow               -7.6%

If we take a longer term approach the S&P has declined to the up trend-line channel support from the 2016 lows and the 200 day moving average.   In the meantime, volatility has risen dramatically and we are hitting oversold levels that are consistent with prior bottoms.  Typically the index will take a few weeks or months to find a true bottom.  Many times it will retest the first reaction low after a failed attempted rally which would bring last Thursday's low into play.  Assuming the markets remain in a bull trend, it is highly likely that the markets are closer to establishing a low and turning higher.  Of course, our assumptions could be wrong and instead this could be the beginning of a bigger downturn.  Over the next few weeks we will be looking for some evidence that the selling is exhausted so the markets can move higher.  Until then, patience and caution is warranted.

Breadth has been lagging for months and price finally broke down from the negative divergence.  However, we are seeing a massive flush in breadth as the percentage of stocks trading above their 50-day moving average is at levels typically associated with a market bounce.  

Sentiment has reversed and become washed out creating a contrary buy signal.  According to the October BAML fund manager survey, allocation to US equities reverses much of the climb in Aug/Sept falling 17 ppt to 4% overweight.  The US is no longer the most favored equity region globally.  FMS investors are the most bearish on global growth since 2008 as cash has become a crowded position.  On top of that the current CNN fear and greed indicator is flashing extreme fear.

The quantitative data sets up favorably for the remaining year and even into next year.
Below are some quantitative studies, courtesy of Nautilus research, that show how current momentum justifies future upside. 

• A new multi-year high for the Dow for the first time in six months is a powerful trend following signal. 6-month gains average +6% (30 up vs. 7 down) going back to 1900. 

• When the SPX and the DOW both make multi-year highs on the same day for the first time in six months, gains for the SPX average +11% one year out and +20% two years out. The Dow Industrials tend to perform similarly. 

• Further, please note that when the DOW Industrial Index is up between 5% and 10% through 9/20, returns for the rest of the year average +7.53% (9 up vs 1 down), while the SPX gains an additional +6% through year end (9 up vs 0 down). 

•  Since 1927, when the SP500 is up more than 8% through September, rest of year gains have averaged +4.02%. (31 up vs. 7 down).  

• Since 1927, when Q3 returns for the SPX exceed 7%, 6-month returns average +9.31% (17 up vs. 5 down) while 3-month returns average 4.53% (18 up vs 4 down). 

•  The SPX just notched 6 straight consecutive monthly higher closes. 3-month returns average +3.85%. (23 up vs 4 down).

In summary, while the recent correction has wiped out months of gains, the pain is always worse on the downside.  Volatility has exploded but has created a wash out in breadth and sentiment.  Along with the favorable quantitative data, the recent flush has reset expectations allowing for a potential year end rally.  The odds favor a bottom being creating over the next few weeks rather then this turning into a full blown bear.