Over at Seeking Alpha, Eric Parnell, CFA, has written an interesting post entitled A Bear Market has Two Phases. In it he posits, based on evidence from the last two bear markets (early 2000s and 2007-2009), that there are two phase to a bear market. In the first phase, the leading sector(s) of the previous bull market breaks while other sectors hold up. In the second phase, the rest of the market follows suit in a general liquidation.

In the bear market of the early 2000s, it was technology stocks that were the first to break, beginning their decline in March of 2000. The great late 1990s bull market had been highly concentrated among technology, telecom and multinational growth stocks, while the rest of the market had been almost neglected. While technology stocks, represented by the SPDR Select Sector Technology ETF (XLK) had fallen 64% by August 2001, the rest of the market hadn't really declined much at all. The general market was attempting to rally in mid 2001. Then after the terrorist attacks of 2001, the general liquidation began, which carried right through until the announcement of the launch of the Iraq War in [   ] 2003.

The bull market in the mid 2000s was led by the financial sector, including it's close cousin, the homebuilding sector. In the bear market of 2007-2009, it was financial stocks that were the first to break, beginning their decline in 2007, culminating in the failure of Bear Stearns later that year. The market then attempted a rally, although financial stocks failed to regain their high. Stress returned in the summer of 2008, culminating in events around the failure of Lehman Brothers in September 2008 and the general liquidation and chaos which ensued after that.

Mr. Parnell shows good illustrations of the theory through use of the Sector SPDR ETFs. What he does not do, however, is lay the theory on top of the current business cycle. To look at the current cycle, one would have to (1) identify the leading sector and (2) spot its decline ahead of the rest of the market.

The Clear Bear Case: Energy is the Leading Sector

The easy case that we have entered a bear market under this theory would be to identify energy as the leading sector (and its relatives in materials and emerging markets). If we look at the energy sector ETF (XLE), we can see that it peaked in June of 2014 and is now off 40% from its high. The materials sector ETF (XLB) peaked in February of 2015 and is now off 20% from its high and industrials (XLI) also peaked in February and are off 15%. (It's also worth pointing out that valuations on speculative tech companies…the sector I am personally involved with…also appears to have peaked in February 2015.)

The rest of the sectors (except interest rate-sensitive utilities), peaked in May-July 2015 and are were only down mid-single-digit percentages as of Friday August 21. It would be easy to then say that energy was the leading sector both in the market, and in the economy with the fracking boom, and that China was the secondary leader, and both are in big bear markets and the rest of the market and economy is finally catching on.

The Not-so-clear Bear Case: Consumer Discretionary is the leading sector

If you look at the numbers, however, it's hard to make the case that energy was/is the leading sector of the recent/current bull market. While energy far outpaced the S&P 500 in the bull market of 2003-2007, it actually underperformed in the bull market from 2009 to its peak in 2014 and its peak was only 14% higher than its previous peak in 2008. In my personal view, energy, commodities and emerging markets are more tied to the dollar cycle than the core market and are rarely likely to be a lead market sector in the US. The dollar cycle drives the 3 business cycle, disinflationary-reflationary-balanced model that I use to set over-weights and under-weights within my portfolio. In 2013 (in my last post…egad I've been slacking), I suggested that we were transitioning from a balanced cycle (the "Rounded Bottom" scenario of 2009-2012/3) to a disinflationary cycle (the "subdued mid-late 1990s" thesis).

As I said then:

My core base case at this time is that we are in the midst of a regime change in the market driven by a shift in the economic cycle. The timing of economic and credit cycles both in the US and abroad should be turning the market relationships of the last 10 years on their heads. I'll cut to the chase: over the next several years I expect the dollar to strengthen, I expect growth stocks to outperform value stocks, I expect real interest rates to rise and bond prices to fall (but only modestly), I expect inflation to remain subdued, I expect commodity prices to fall, I expect emerging markets to have problems, I expect Europe and Japan to recover modestly, and I expect US real estate to perform ok.

Cyclically, I would compare where we are today to a subdued version of the mid-1990s.

Not to pat myself on the back, but the thesis is actually playing out in the markets. Economically, the recent, energy, emerging market and commodities crash would be analogous to the emerging market crash of 1997-1998, which cemented the trend of a global allocation of capital to the US, which then flowed into an investment and consumer spending boom of epic proportions, led by technology and telecom.

Why do I think the economy and market will be more subdued than the 1990s? This time around, the underlying cycle has been much slower to turn than in the 1990s due to higher debt levels and lower inflation. The market cycle has turned up faster than the economy due to the corresponding low interest rates and quantitative easing. Whereas in the 1990s there was latent capacity for the global economy to lever up with more debt (a process that continued into the early 2000s), in the post-financial crisis world the trend has been de-leveraging, particularly in the private sector.

That said, there is pent-up demand for capital investment after the under-investment of the past decade and a lack of true excess in the US system that sets us up for disaster (as far as I can see). I therefore find it unlikely that we are staring at a recession in the very near term caused by a slowdown in energy and emerging markets. And it would be highly unlikely if we were heading for a generalized bear market if we weren't also headed for a recession.

If we look at the performance of the stock market, it should be noted that the broader market peaked along with the lead sector in early 2000 and 2007. The broader market fell, then rallied but failed to regain their highs at the beginning of bear market phase two. In the most recent case, the market has continued to make news highs in the year after energy stocks and emerging markets began their bear market in 2014. Don't get me wrong, overall market breadth has clearly deteriorated, with the above-mentioned breakdowns in industrials, utilities, speculative tech and transportation in early 2015, but the actual lead sectors and the market as a whole have made new highs. 

So what have actually been the lead sectors of the market? Using the sector ETFs, the clear winner is the Consumer Discretionary SPDR (XLY). At its recent peak in July, the XLY was up 392% from its trough in March 2009 (vs. 209%) and was up 100% from its previous peak in 2007. The top holdings of the XLY include Amazon, Disney, Comcast, Home Depot, McDonalds, Starbucks, Nike, Netflix, Time Warner, Priceline, Lowe's…media, internet retail, home improvement, restaurants, automakers, etc. In other words, growth stocks levered to the US consumer. The other leading sector has been the Health Care SPDR (XLV). At its recent peak in July it was 245% above its trough in March of 2009 and 100% above its peak in 2007. Both sectors are levered to the US, so are less affected by a strong dollar. The XLY, however, is cyclical and highly vulnerable to a recession and the XLV is vulnerable to big changes in the health care laws (i.e. vulnerable to a GOP electoral sweep on the right or a Bernie Sanders win on the left).

So are we starting a bear market or not?

Of course nobody really knows the answer to that. If past patterns hold, a bear market starting now would play out as follows: the market has a big downturn/correction through September/October, with the losses slowing soon and accelerating again near the end. The XLV and XLY lead the way down. The Fed steps up and does/says something to assuage the markets and the broader market rallies with many sectors nearing their old highs but the XLV and XLY would remain way off. The broad market fails to retake its high by next summer. The selling then resumes, with a broad selloff cascading through next fall and beyond. And a recession beginning in early-mid 2016.

I'll call this my alternate hypothesis.

I suspect we're not there yet. I think we are definitely in the late innings of this bull market, but not in the 9th. There is no over-arching reason today for the big economic trends to break. I expect another rally higher, but with far narrower breadth, as industrials, materials, energy, utilities, transports and maybe financials fail to keep pace with a rally led by consumer discretionary, health care and technology. The dollar resumes its rise, squeezing broad corporate profits, which the market ignores for a while. Eventually however the lack of global demand relative to over-optimistic US investing and deflationary forces around the world (a renewed Euro crisis, a second wave of emerging market problems, a true financial crisis in China?) will finally pull us under.

That's my base case (for now).

I am not your financial adviser. I write these articles purely for my own amusement. Please consult your own financial adviser before acting on any of the opinions expressed herein.