Was the sell-off in December the bottom of a bear market? asks Jim Stack, a top-performing money manager, noted market historian and editor of InvesTech Research.

The steep decline seen at the end of 2018 did not meet the technical definition of a bear market for the DOw or the S&P 500, however it came extremely close. While the difference between -19.8% and -20.0% is trivial, it is more about the inherent risks and excesses than the absolute value of the decline.

Virtually all bear markets dating back to 1933 have taken back 50% or more of the previous bull market’s gains (with the exception being 1956). Had the 2018 market decline logged as an official bear market, it would have been the smallest on record in terms of bull market gains repossessed.

To put this in perspective, a 50% recapture of this bull market’s gains would result in the S&P 500 falling roughly -38.5% from the September 2018 high — approximately twice as much as the decline experienced in 2018.

At this stage of a mature economic expansion and bull market that have persisted for nearly a decade, our historical perspective on market cycles tells us that this simply wasn’t “it.”

As painful as it may have seemed, we simply did not resolve enough market excesses or reset investor psychology. December was just a fire drill; a preview for the bear market that will eventually come when the U.S. enters the next economic recession.

S&P 500 corporate earnings have benefitted from numerous tailwinds over the last couple years due to corporate tax cuts and continued economic growth.

However, expectations for 2019 are incorporating falling global growth, political uncertainty, and rising input costs. These factors have put substantial pressure on company earnings predictions and, as shown by the quotes below, many are anticipating a possible earnings downturn.

In fact, no one has been more bearish on forward growth expectations than corporate management itself. To date, approximately 70% of companies in the S&P 500 have reported results for the fourth quarter of 2018.

During those earnings announcements, the number of companies issuing negative forward guidance for the first quarter of 2019 has outweighed positive guidance by more than a 4-to-1 margin. While investors are feeling more positive about the outlook for 2019, corporations seem to envision a different picture.

With almost 40 years of operating InvesTech Research, we have seen a lot of economic cycles and bear markets. While bear markets can occur without an accompanying recession (e.g., 1966 and the 1987 Crash), there is clearly a defined link between the two. And quite often, recessions are not recognized by media headlines until a year or more after the bull market peak — including the past two.

While the Federal Reserve has bought time — and maybe even new bull market highs — with their flip-flop on monetary outlook and interest rates, the underlying risks in this aged bull market still exist. The simple fact is that stocks are not cheap today.

While the S&P 500 Price-to-Earnings Ratio has eased closer to its 60-year norm — aided by the Trump corporate tax cuts — today’s figure is based on peak profit margins that are likely unsustainable.

In addition, many of the excesses built up through 9+ years of economic expansion were not resolved by the brief bout of selling panic in December. Over recent years, a record amount of low rated Junk Bonds have been issued, and non-financial business debt is significantly higher than it was at the start of the last recession. This problem could easily turn into the next debt crisis in an economic downturn.

Recessions are a healthy part of long-term economic growth, as they have a cleansing effect on debt, leverage, and excessive exuberance — at both the consumer and investor level. We cannot yet say if a recession is on the imminent horizon.

However, going ten years without a recession presents an increased danger that should not be taken lightly. While the day of reckoning may be postponed by the Fed’s reversion to a dovish stance, it guarantees that December’s emotional sell-off will pale against the damage of the next bear market.

Subscribe to Jim Stack's InvesTech Research here…