Steep stock losses have some investors loaded for bear

NEW YORK (Reuters) - After a six-day span in which the benchmark Standard & Poor's 500 dropped 11 percent, some fund managers and analysts on Wall Street are raising the possibility that a bear market may be looming for the first time since 2009.

For much of the rally, corrections – declines of 10 percent - have been brief, as investors were always ready to jump in, betting that low interest rates and a slow-but-steady economic expansion would boost shares. Stock repurchases and high dividends supported equity investments as well.

And while the market had slipped a bit from its peak in late May, few seemed worried, even if buying enthusiasm had slipped.

That changed about a week ago with the selloff out of China that hit markets worldwide, caused commodity prices to plunge and raised doubts about earnings and growth while also calling into question whether central-bank support could make a difference after years of loose policy.

"I think there is a high risk of a bear market," said Mike O'Rourke, chief market strategist at Jones Trading. "All these things that were tailwinds for recovery have turned into headwinds."   

U.S. markets rebounded on Wednesday, providing a respite for investors. With the S&P 500's 3.9 percent gain to 1,940.51, it means that for the market to enter bear-market territory – a 20 percent decline from its closing peak - it would need to fall more than 200 points, to about 1704.

Still, the list of concerns is long, and begins with the slowdown in China's economy, now believed to be expanding at its most tepid pace in two decades. At the same time, the Federal Reserve may be on the cusp of raising interest rates for the first time in nearly a decade.

Higher rates and a less robust China could hinder the sluggish growth of the U.S. economy and strengthen the dollar, further eating into weak earnings expectations for the second quarter. The focus on those headwinds, along with market valuations that still strike some as expensive, has sapped buying interest.   

The most sign of the change in sentiment was seen Tuesday, when the S&P 500 closed 4 percent lower than its session highs, causing some to realize that buyers are currently not taking advantage of the dips with more purchases.

"When you close at the low of the day, it's an important signal," said Jack Ablin, chief investment officer at BMO Private Bank in Chicago. "The economy is solid but the financial markets are ripe for some kind of correction."

The sharp declines have also resulted in a big move higher in volatility. On Monday, the CBOE Volatility Index <.vix>, the market's favored barometer of investor anxiety, shot up 25 points to 53.29, highest since January 2009. While it has receded since then, it closed Wednesday at 30.32. A reading greater than 30 is associated with periods of greater worry.

"It's running at sort of crisis level values," said Andrew Wilkinson, chief market strategist at Interactive Brokers LLC in Greenwich, Connecticut.

Investors have responded to the gyrations by adding to protection against losses. The number of bearish put options trading, compared with bullish call options, on all U.S-listed stocks and indexes is at its highest level in nearly four years.

"My sense is that people are hedging entire portfolios particularly in light of the jump in the volatility index, which tells you that premiums are being driven by fear,” Wilkinson said.

The 10-day moving average of overall put volume relative to call volume hit 1.1 on Tuesday, the highest since October 2011, according to options analytics firm Trade Alert data.

Volume in the iPath S&P 500 VIX Short-Term Futures exchange-traded note , which gives investors exposure to VIX futures contracts, saw its four biggest days of activity between Friday and Wednesday in its history, with more than 758 million shares combined on those days.

   

BREAKDOWN

To be sure, some strategists say the recent volatility in the stock market is overdue and should be expected at a time when the Federal Reserve is moving closer to raising interest rates.

The S&P 500 last dropped by 10 percent or more in August 2011, a four-year span six times longer than average number of trading days between such declines, said Bill Stone, chief investment officer at PNC Asset Management Group. That long interval led investors to become overconfident and pushed stock valuations too high, he said.

Stone said he does not expect the index to fall by the 20 percent that defines a bear market.

"It's hard to feel really good while the markets are so volatile but people will look back and say that this cleared the decks and took us from overbought conditions to oversold," Stone said.

An improving U.S. housing market, strong employment numbers and the possibility of improved margins because of the declining value of the yuan could all help send corporate results higher than analysts expect in the next earnings season, he said.

As of yet, estimates have not declined by much. S&P per-share earnings for the next 12 months are expected to come in at $123.84, putting a price-to-earnings ratio of 15.1 on the S&P, according to Thomson Reuters data, broadly in line with the historic average.

Earnings estimates overall are down 1 percent from one month ago, when the P/E was 16.8, but worries about growth could force analysts to cut estimates, making it possible that prices would have to fall further for valuations to adjust. Compared to sales, Ablin said he believes stocks are overvalued by 10 to 15 percent.

   

BORN TO RUN

Before Wednesday's gains, the S&P 500 had fallen by 1 percent or more for four consecutive trading days, the longest consecutive streak of losses of that size since the bear market low in March 2009, said Jason Goepfert of Sundial Capital Research. Yet five of the seven streaks of losses of that size over the last 50 years have marked a market low, with the market averaging a gain of 24 percent over the following 12 months. 

The volatility of the market over the coming weeks will likely influence whether the Fed ultimately decides to raise rates at its September meeting, said Jim McDonald, chief investment strategist at Northern Trust in Chicago. Yet even if the economic data remains strong, he doesn't see a rebound just yet.

"We shouldn’t expect the market to start marching upwards from here," he said. "It needs some time to heal."

(Reporting by David Randall and Saqib Ahmed, additional reporting by Rodrigo Campos. Editing by David Gaffen and John Pickering)