Is A Bear Market Forming?

This will be a long and fairly involved article. However, there is a lot of ground to cover. So, let's start with the charts of the market.

SPYs or S&P 500

First, I don't look at the Dow Jones Industrial Average. It's 30 stocks whereas the S&P 500 is 500 and represents a far larger swath of the market. In addition, I use the tracking stocks for all the averages.

Let's start with the five year weekly chart. Notice the SPYs traded in un upward sloping channel since the beginning of 2004. They broke through the top trendline at the end of 2006 and bounced off this line at the end of the first quarter of 2007. Then the SPYs went to form a double top in 2007. In early July of last year Bear Stearns announced two of their hedge funds were in serious trouble and the credit crisis started. As a result, the SPYs fell through both of the trend lines of their upward sloping channel. In early 2008 they formed a double bottom, with the second bottom occurring when the Federal Reserve backstopped JP Morgan's purchase of Bear Stearns. Since then the SPYs have been rallying. However, over the last few weeks the SPYs have dropped hard moving through the lower trend line of the upward sloping channel the index originally formed in 2004.

Above is a one year daily chart of the SPYs which I have included to better show the action over the last year. Notice the following:

-- Prices are below the 200 day simple moving average (SMA) -- bear market territory

-- Prices have dropped about 18% from their highs

-- Prices are clearly below the lower trend line of the upward sloping channel the average started in 2004

On the three month chart, notice the following:

-- Prices are below the 200 day SMa

-- All the SMAs are moving lower

-- Prices are below all the SMAs

-- The shorter SMAs are below the longer SMAs

This is the most bearish simple moving average orientation a chart can have.

The NASDAQ 100 or QQQQs

There are two important trends with the QQQQs. The first is an upward sloping channel that started at the beginning of 2004. This trend channel is still intact. The second trend started in mid-2006 and constituted an upward sloping rally from mid-2006 to the beginning of 2008 when the QQQQs fell through this trend line. So, the long-term upward sloping trend remains intact, but the shorter rally is clearly over.

On the one year QQQQ chart, notice three things:

-- The rally that started in mid-March of this year is over, and

-- Prices are below the 200 day SMA

-- Giving the chart a very conservative eyeballing, it's down 16.62% from its late October, early November highs

On the three month chart, notice the following:

-- Prices are below the 200 day SMA

-- Prices are below all the SMAs

-- The 10 and 20 day SMA are headed lower

-- The 10 and 20 day SMA has crossed below the 50 and 200 day SMA

This chart is not entirely bearish year. The longer-term averages (50 and 200 day SMAs) are still bullish. However, with prices and the shorter SMAs below these numbers that won't last for much longer.

On the IWMs 5-year weekly chart, notice the average was in a clear upward sloping channel until late 2007/early 2008 when the average broke through the lower trend line. Since then the average has fallen to the 200 week SMA and has fallen through that important trend line twice. The IWMs formed a double bottom in early 2008 and rallied after the second bottom. The IWMs moved into the 50 week SMA but fell from that SMA and are now through the 200 week SMA again.

On the yearly chart, notice the IWMs were in a clear downward sloping trend from teh end of September to the beginning of March. They index continually moved lower forming consolidation patterns along the way down. This chart also clearly shows the double bottom and the ensuing rally. From the highs of last summer to the current price, the index has dropped about 18%.

On the three month chart, notice the following:

-- Prices broke through the 200 day SMA but couldn't maintain momentum

-- Prices are now below all the SMAs

-- The shorter SMAs are below the longer SMas

-- The 10 and 20 day SMA are both headed lower

-- The 10 day SMA broke through the 50 day SMA and the 20 day SMA is about to cross below the 50 day SMA

In other words, this chart is moving into a very bearish orientation.

So far we have the following:

-- The SPYs and the IWMs are in a very bearish formation

-- The QQQQs are in a neutral bearish formation.

Let's look at the fundamental picture.

The Fed

In their last policy statement, the Fed signaled they are done lowering rates:

The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time. Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

In addition, after adjusting for inflation interest rates are already negative, so there isn't much point in cutting rates further.

Upward Moving Commodity Pricing Pressures

The CRB index is up 53% since August of last year. It is in a clear rally. Notice that as prices have increased they have taken the time to consolidate gains before moving higher. Also notice the following:

-- All the SMAs are moving higher

-- The shorter SMAs are above the longer SMAs

-- Price are above all the SMAs

This is a very bullish chart

Agricultural prices have been in a three year rally, although they started to correct from this rally earlier this year and broke through key upward sloping support. However, the situation in the US mid-west gave agricultural prices a bid and they have since moved higher. But also note they could be forming a double top here. Also notice the following:

-- Prices are above all the SMAs

-- All the SMAs are moving higher

-- The 10 week SMA moved below the 20 week SMA, altghough the 10 week SMA is still moving higher

This is also a very bullish chart, although we'll have to wait and see how the possible double top plays out.

Oil is the 800 pound gorilla in the room. This chart is incredibly bullish. First, notice that for the last year oil has continually moved higher. As it has moved higher it has consolidated gains and then made hew highs. Also notice the following:

-- Prices are above all the SMAs

-- The shorter SMAs are above the longer SMAs

-- All the SMAs are moving higher

This chart is about as bullish as you can get.

So, we have spiking commodity prices hemming in the Fed and consumer spending. In addition, the "stimulus" package is about over; we've got maybe another 2-3 months of mileage from that move. In other words, the possible policy responses from Washington are gone.

The Dollar

The dollar's low value causes two problems. First, it hems in the Federal Reserve's interest rate policy. Low interest rates lower the value of a currency. In addition, various federal officials have made public pronouncements about the dollar over the last few weeks, indicating they are keeping a close eye on the dollar's overall value.

The above weekly chart of the dollar is a great example of a bear market chart. Notice the following:

-- Prices have continually moved lower, breaking through support levels and consolidating gains

-- The 20 and 50 week SMA are still moving lower

-- Although the 10 week SMA has turned positive, it has down this several times over the course of the last few years with little change in the dollar's overall direction. In order for this change of direction to translate into a move higher for the dollar, we'll probably need to see actual Fed action rather than the usual "we have a strong dollar policy" talk.

-- The chart is still in a clear downward sloping trajectory

Housing

Housing is nowhere near bottom (graphs from Calculated Risk). First there is a ton of inventory on the market:

And there is a ton of inventory as expressed by the months of inventory available for sale:

This is leading to huge declines in home prices:

Home prices across 20 major U.S. cities have dropped a record 15.3% in the past year and are now back to where they were in the summer of 2004, according to the Case-Shiller home price index released Tuesday by Standard & Poor's.

Prices in the 20 cities are now down 17.8% from the peak two years ago.

Prices were lower in April than they were a year earlier in all 20 of the major metropolitan areas as tracked by the Case-Shiller index.

Notice the low consumer sentiment and confidence numbers below that indicate the consumer will not be purchasing a lot of homes in the near future.

A Consumer Under Pressure

Add to all this a deteriorating picture for the consumer. Consider the following charts from econoday:

Job growth is slowing, leading to

Increasing unemployment which is

Lowering consumer confidence and

Consumer sentiment is falling off a cliff.

The Financial Sector

Here is part of an article I wrote recently on the FDIC's quarterly banking profile.

Deteriorating asset quality concentrated in real estate loan portfolios continued to take a toll on the earnings performance of many insured institutions in first quarter 2008. Higher loss provisions were the primary reason that industry earnings for the quarter totaled only $19.3 billion, compared to $35.6 billion a year earlier. FDIC-insured commercial banks and savings institutions set aside $37.1 billion in loan-loss provisions during the quarter, more than four times the $9.2 billion set aside in first quarter 2007. Provisions absorbed 24 percent of the industry's net operating revenue (net interest income plus total noninterest income) in the quarter, compared to only 6 percent in the first quarter of 2007. The average return on assets (ROA) was 0.59 percent, falling from 1.20 percent in first quarter 2007. The first quarter's ROA is the second-lowest since fourth quarter 1991. The downward trend in profitability was relatively broad: slightly more than half of all insured institutions (50.4 percent) reported year-over-year declines in quarterly earnings. However, the brunt of the earnings decline was borne by larger institutions. Almost two out of every three institutions with more than $10 billion in assets (62.4 percent) reported lower net income in the first quarter, and four large institutions accounted for more than half of the $16.3-billion decline in industry net income.

Let's take this apart piece by piece.

Higher loss provisions were the primary reason that industry earnings for the quarter totaled only $19.3 billion, compared to $35.6 billion a year earlier.

In other words, losses nearly cut earnings in half on a year over year basis. That's a very sharp reduction.

FDIC-insured commercial banks and savings institutions set aside $37.1 billion in loan-loss provisions during the quarter, more than four times the $9.2 billion set aside in first quarter 2007.

Financial institutions are anticipating far more losses - nearly four times as much -- than they were a year ago. That indicates the credit quality of the underlying loans is cratering.

Provisions absorbed 24 percent of the industry's net operating revenue (net interest income plus total noninterest income) in the quarter, compared to only 6 percent in the first quarter of 2007.

Loan loss provisions now consume four times the industry's net operating income. That's a huge year over year increase.

The average return on assets (ROA) was 0.59 percent, falling from 1.20 percent in first quarter 2007. The first quarter's ROA is the second-lowest since fourth quarter 1991.

The industry's return on assets is almost 50% lower on a year over year basis. Again -- that's a precipitous drop in a short time.

The downward trend in profitability was relatively broad: slightly more than half of all insured institutions (50.4 percent) reported year-over-year declines in quarterly earnings. However, the brunt of the earnings decline was borne by larger institutions. Almost two out of every three institutions with more than $10 billion in assets (62.4 percent) reported lower net income in the first quarter, and four large institutions accounted for more than half of the $16.3-billion decline in industry net income.

This is a very troubling development. If a large institution fails it will send a ripple effect through the entire financial industry.

So, the short version of the FDIC report is clear: the financial industry is still in serious trouble.

I want to caution, we're nowhere near meltdown mode. There is no panic, not should there be one. The sector is still working. However, instead of being able to get to fifth gear it can only get to second gear.

Simply put, this indicates the financial sector is still in a very bad place.

So, let's sum up.

1.) Two of the three stock market averages are in poor technical shape. This lone hold-out (the QQQQs) are in a neutral position.

2.) The Federal Reserve has already lowered rates. Inflationary pressures and a dropping dollar will hem in their ability to lower rates further

3.) Inflation is increasing

4.) Housing is nowhere near bottom as indicated buy the bloated inventory and dropping prices

5.) The consumer has no confidence going forward

6.) The financial sector is not in good shape.

In other words, the technical picture is poor and the fundamental picture is poor.