There’s Something Happening Here: The Evolution Of The Bear

There’s something happening here.  What it is ain’t exactly clear….. There’s battle lines being drawn.

– Buffalo Springfield, “For What It’s Worth”

Sooner or later in a bear market, even the glory stocks start to come apart.

As a bull market ages and becomes a bear market, stock groups turn down one by one, until even the strongest roll over.  That may be happening now to energy and other commodity related stocks.

– “Bear Trap Opens for Resource Stocks” (subscription required), E.S. Browning, The Wall Street Journal, Monday July 7

The climactic selloff of Tuesday July 15th seems to have marked a significant inflection point for financial markets.  Oil and the Euro put in a major top that day and have been selling off since while the financials put in a significant bottom and have been holding up well. 

The charts tell the story better than words ever could: USO 3 Month Chart (Oil), $ Euro 2 Month Chart ($/Euro), XLF 3 Month Chart (Financials).

What does it mean?

Oil, the premier commodity, continued to trade strong through the first half of this year even though the US economy was in the tank on the premise that worldwide growth would continue to be strong.  Indeed, all commodities and commodity stocks did.

Over the last 3 1/2 weeks, that premise has lost credibility. 

Yesterday, ECB President Jean Claude Trichet suggested that the European economy might be weaker than previously realized and investors sold off the Euro in anticipation of a rate cut on the horizon (“Dollar Rallies Against Euro After ECB Admits Growth Risks” (subscription required), The Wall Street Journal, Friday August 8th).

What this could mean is that we are witnessing an evolution in the bear market as the global economy and investors begin to reckon with the second order effects of the US housing bust. 

That is, the first stage of this bear market has been marked by the housing bust and its immediate effects on banks and consumer discretionary companies – primarly in the US.  Now, this is mostly priced in – the bottoming of the financials is evidence for this – but economies and investors are starting to feel the effects of the US bust on the rest of the world. 

Exports to the US are a huge part of the economies of the emerging markets.  Sky high commodity prices are in the end linked to US consumer demand.  Falling US demand means falling commodity prices – which in itself hurts many emerging market economies which are heavily weighted towards commodities – and decreased demand for exports which means unemployment and declining income overseas.

What this probably means for financial markets is that commodities, emerging markets, infrascture plays, etc… which have until recently been so strong are now broken and will lead on the downside.  Financials and consumer discretionary stocks might not be strong but they will no longer lead on the downside.