The stock market is no longer raging higher as it was in 2020. But don't doubt for a second that it is still very much a bull market for the foreseeable future. Thus, we should have an ample allocation to the stock market, says Steve Reitmeister, editor of Reitmeister Total Return.

With that bullish outlook so clear, then I thought it would be interesting to spend our time today talking about the elements that could eventually bring the next bear market out of hibernation. The more prepared we are for those potential outcomes, the more alert we will be to get defensive at the right time.

Market Commentary

Now back to the main topic of the day. That being the things that could potentially bring this bull party to and end with the next bear market ready to emerge.

On the simplest level we know that there are two main catalysts behind bear markets.

1) Economic Decline (Ex. Recession): When storm clouds circle over the economy and it darkens the outlook for corporate earnings then share prices naturally decline. This is the most prevalent catalyst that ignites a bear market.

2) Valuation Bubble: The value of the stock market gets so stretched that the only logical direction to go is down. This is much less common than the bear emerging from economic decline. However, in recent memory we have the bear market that emerged in 2000 as the tech bubble burst. And then you have the 1929 stock market bubble that imploded so badly that it kick started the Great Depression. But indeed, it was stock valuation issues that got things rolling in the wrong direction.

So in general we need to discuss events that could trigger either one of these events. Here are the ones that come to mind in descending order of probability:

Persistently High Inflation: High inflation is often a precursor to economic decline and bear markets. That’s because consumers become so worried that inflation will only get worse that it leads to them consuming a lot more in the present for fear of prices being too high in the future.

At first the economy looks better from all that extra spending. But on the flip side of that is a pullback in spending, which is the very definition of economic decline and recession.

No doubt you have seen countless articles in the past few months talking about inflation being 4-6% higher than last year. However, there is a good reason to believe this is just a short-term hiccup as we are comparing today’s improving economy versus last year’s Covid-inspired economic disaster. The Fed is the most vocal about the transitory nature of this recent inflation, which explains why they have taken no steps to tame inflation.

However, what if the Fed is wrong...and inflation does become a bit more permanent? In that case, then investors need to appreciate the negative consequences that come with that and become more defensive.

Higher Interest Rates: So, if the historic low-rate environment is the main catalyst for the bull market...then the removal of that catalyst could indeed awaken the next bear market. But really, anyone reading my commentary for the past 18 months knows that low rates is the primary reason for this bull market.

The abbreviated explanation is to say that when 10-year Treasury rates rise up closer to the earnings yield of the stock market (4.3%) then more investors will move out of stocks. Given that rates are under 1.4% at this time says there is still a lot of blue sky ahead for stocks before this catalyst kicks in.

Unfortunately all that blue sky for stocks is what could get valuations so stretched according to other traditional metrics like PE. So, it is possible that the low-rate environment lasts for so long that stocks just press higher and higher since still cheaper than bonds. Then they get to an unsustainable bubble level that kicks the next bear-market environment into place.

Coronavirus: Imagine that the Delta variant is not the last mutation of the coronavirus. What if instead a much more deadly version emerges...especially one that renders all current vaccines useless.

No doubt you appreciate that this would be a very bearish event. That’s because it would come hand in hand with more societal shutdowns that is most certainly a negative for the overall economy.

These three are the most likely scenarios to end this bull market. And thus, it is prudent that we watch the signs vigorously to know when it is time to get more defensive in our portfolios.

Further, when it becomes 100% clear the bear market is at hand, then we would shift from defensive to downright aggressive, by leaning into the downward action with the ease of use of inverse ETFs. That is a much longer conversation that we will save for when the time is at hand. But for now, just know that our goal is not to “survive” a bear market. Rather our goal is to “thrive” as there is plenty of money to be made as stock prices head lower.

Yes, there are more than these three scenarios to consider. However, most would be in the “Black Swan” or out of nowhere category. Even the idea of a trade war with China fits in this category as there is no serious concern of that happening now. But if and when one of these economy-shaking events takes place, we would then assess the bear market potential in real time to adjust our investing strategy accordingly.

Gladly none of these bear market catalysts is currently at any level of serious concern. That is why the S&P continues to make new highs month after month.

A great analogy for that is to think of the stock market as a helium balloon. Its natural inclination is to float higher. Thus, it takes some stronger, opposing force to hold it down like the ones we discussed above. And when those obstacles are removed the market gets back to its native state of rising higher.

That is why we continue with the bullish bias in our portfolio, which is panning out for us quite handsomely. More details on that to follow...

Portfolio Update

The market was flat week over week and gladly we were a notch better than that. However, consumer-oriented stocks continued to be out of favor. And yes, our shift out of BC and SNBR yesterday was a nod to the fact that we may have been a touch too overweight that group. Gladly we were able to replace them with two very attractive picks. That is where we will pick up the conversation on our portfolio...

Yesterday’s Additions (APA & WDC): We added both of these shares at the opening bell. Note that both of these are higher-beta plays. Meaning their prices will swing wildly in the market winds. But because I see the market as still favorably bullish and there are clear positives for their industry groups...then that higher beta should work in our favor over time. Just try not to get to upset whenever they have an off day or two. Because however fast they drop, they can bounce back with equal ferocity.

Cirrus Logic (CRUS): Shares have been doing pretty well out of the getgo. Gladly they got an extra jolt of praise from Barclays where the analyst sees them benefiting handsomely from the Apple relationship over the next few years, which leads to higher growth ahead. This compelled the analyst to upgrade shares to Overweight (which I think is a funny compliment ;-) and fresh target of $100.

Kulicke & Soffa (KLIC): Our other semiconductor pick has blasted through resistance at $70 and enjoying a breakout to new highs. We have already taken some profit off the table on these shares so no desire to bag more gains til we see how high this stock can fly. Especially true given the strong industry fundamentals at play. And especially true how glorious their last earnings report was (often a company on this kind of roll can have several quarters of fantastic results and you don’t want to bail out before it has all unfolded). So, at this stage we hold on to shares until the company gives us a reason to sell (like lackluster earnings results).

Insperity (NSP): Break above $110 in place thanks to +3.15% session on Thursday. And now up +42.45% since inception. The favorable employment trends in place are indeed the friend of NSP shares.

Schieder National (SNDR): Shares have come out of their slumber and making nice headway of late. Soon will be another double digit winner in the banks and looking for it to keep trucking to $25+ into their next earnings announcement.

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