Stocks may be heading for a bear market

September trading got off to an inauspicious start on Tuesday, with stocks reversing the gains earned in the previous week in a return to the volatile selling seen earlier last week.

In the end on Tuesday, the Dow Jones industrial average lost 2.8 percent, or nearly 470 points, to close just above 16,000.

Concerns continue to build about the situation in China and the odds of a Federal Reserve interest rate hike on Sept. 17 -- with all eyes on the August payroll report due Friday. Confusion reigns as the latest Bloomberg survey shows that 48 percent of 54 economists expect a September rate hike, down from 77 percent in early August but nearly double the number expecting a delay until December.

In China on Tuesday, the Shanghai Composite lost 1.2 percent after the official manufacturing index (PMI) fell to a three-year low. Contagion seems to be spreading in Asia, raising fears of competitive currency devaluations as South Korean exports dropped 17.4 percent in August for the worst result in six years. Taiwan's manufacturing PMI came in at a three-year low and has been in contraction territory for five straight months.

The stock market's precipitous drop is beginning to set off alarm bells on Wall Street. Bank of America Merrill Lynch's Michael Hanson's puts the probability of economic recession at nearly 50 percent based on the 15 percent annualized drop in stocks over the last six months.

Admittedly, the model flashed a 59 percent chance of recession during the 2011 market slide. But if stock prices weaken further, the odds will rise.

Technically, the situation looks ugly.

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The Dow fell back to the 16,000 level today, and the S&P 500 has suffered its first "Death Cross" in four years. That's a downward cross of the 50-day moving average below the 200-day moving average, a sign of lost medium-term momentum. The long-term bullish trend is at risk as the index has closed below its 12-month moving average, a strong predictor of bear markets as shown in the chart above.

Unless the bulls mount a historic charge higher here -- ending September 7 percent higher -- it could be game over. And market history isn't on their side.

August ended with more than a 5 percent loss on the S&P 500, the worst performance for the month in 17 years. Tuesday's losses put stocks back into correction territory, down 10.3 percent from their July high.

Could a 20 percent drop, the criteria for a bear market, be on the horizon?

According to Jason Goepfert at SentimenTrader, since 1928 losses of this magnitude in August meant September sported a positive return only four out of 13 times, with an average loss of 5.4 percent. At best, stocks rallied above August's close only by an average of 1.4 percent. At worst, they fell an average of 8.3 percent.

In his words, the data reveals a "terrible risk/reward ratio" in stocks right now.

  • Anthony Mirhaydari

    Anthony Mirhaydari is founder of the Edge , an investment advisory newsletter, and Edge Pro, options newsletter. Previously, he was a markets columnist for MSN Money; a senior research analyst with Markman Capital Insight, a money management firm; and an analyst with Moss Adams focusing on the financial services industry.