Image: Grizzly bear © DLILLC, Corbis

Forget the New Year's celebration and optimism. Shake off the holiday cheer. Ignore the euphoria over the fiscal cliff deal. There is pain coming in 2013 for pretty much everyone, especially investors.

In fact, we could be on the cusp of a powerful new bear market in stocks. The more I review the data and examine the year-ahead research, the more worried I become. Over the past two weeks, I've sketched out why a new recession looms (see "Welcome to the new recession") as well as why it could prove to be a great buying opportunity for the long term (see "A happy new year -- eventually"), in an effort to dull the pain of what's coming.

But first, we've got to trudge through the muck. And the evidence suggests that both Wall Street insiders and Main Street everymen are beginning to position themselves for the pain.

A recent piece by The  Associated Press  provides the basic outline: Average Americans have lost faith in equities and have consistently been selling into strength over the past few years, something that hasn't happened since records started at the end of World War II. Since early 2007, the AP calculates, $380 billion has been pulled out of the market, equivalent to all the money put in between 2002 and 2007. The new craze has been in bonds, a perceived safe haven that has attracted more than $1 trillion since 2007.

Anthony Mirhaydari

Anthony Mirhaydari

I can't say I blame those investors.

Wall Streeters are pulling out, too. Major banks' short-term Treasury bond holdings have surged since 2011's credit-rating downgrade and the subsequent market meltdown. Over the past few weeks, total holdings have climbed to a record, according to Federal Reserve data.

This is the equivalent of hunkering down in a bomb shelter.

Exodus in action

Stocks are unattractive because the economy is unattractive. Deep, structural problems remain unresolved, discouraging fresh money from coming into stocks.

Middle-class households are still struggling with stagnant wages, higher prices for food and fuel, higher medical costs and, now, rising rents. Young adults are on the same tragic trajectory as Japan's lost generation, as economic turmoil is poised to do lasting damage to their lifetime earnings. These folks are having trouble moving out of Mom's house and paying their student loan debt, let alone investing a meaningful portion of their income in equities.

At the same time, boomers are starting to pull money out of stocks as they approach retirement, shifting to bonds and cash in a big way.

The result has been a drop in NYSE market volume to levels not seen since 1998.

Source: Global Financial Data

The thinning has been accompanied by other, related trends: the rise of predatory computer trading algorithms, hedge fund insider-trading shenanigans and cross-asset correlations. For most people, the playing field is not level, and portfolio diversification does not offer the safety it once did. Plus, the heavy hitters now actively play against the little guys, using strategies with names like "momentum ignition" and "quote stuffing."

All this has investors throwing their hands up in disgust. Add in the economic head winds starting to develop -- from corporate profit margin pressure (slowing top line growth and an already streamlined cost structure) to fiscal austerity by rich-world governments (even a best-case bipartisan resolution to the looming debt ceiling fight would see taxes go up further and spending fall) to new recessions in Japan and Europe -- and we're in the early stages of an outright exodus.

Stepping back, this decline in NYSE volume reverses an uptrend that began in the late 1940s -- which itself marked the end of the Great Depression malaise.

Put another way, this is no ordinary market. And traditional rules based on the multigenerational performance of the stock market don't apply -- including the belief that retail investor flows are a contrary indicator worth betting against.

Risk abounds

What's worse is that if the market drops out of the sky next year, it's hard to see any near-term positives breaking the fall. 

Households remain under intense pressure, with the job market stalled and home prices well off their highs. The government and the Federal Reserve have already made exhaustive efforts to solve the problem, as have their overseas equivalents. We've done stimulus fueled by debt and deficit. We've done currency debasement and ultracheap money. Not much is left, as the new leadership in Tokyo tasked with ending Japan's long debt-depression death spiral is about to realize.

Although I mentioned a few positives last week (strong corporate balance sheets and excess liquidity, mainly) the path out of this is tricky and strewn with dangers.

There is the risk of political unrest (witness Greece's violent protests) and gridlock. There is the risk of an outright global currency war as all the major economies try the currency-devaluation trick in a simultaneous push to boost exports -- a war the Brazilians claim to be winning. There is a risk of credit-rating downgrades on a lack of deficit reduction -- which Moody's warned of last week. And there is the risk of a bloody end to the stalemates in the Middle East, with flare-ups possible on the Israeli-Iran, Israeli-Arab and Sunni-Shia fronts.

And the bond market is looking risky as well. As I explained two weeks ago, people are overpaying for the "safety" offered by corporate bonds, ignoring the risk of default or a rise in interest rates. With rates so low, exposure to these risks -- and the potential losses from them -- is much higher than many realize.

(Bond traders are already familiar with this concept, known as "duration," that results in steeper losses on small increases in interest rates. Lower overall interest rates, all else equal, will increase duration and therefore exposure to losses.)

From a purely technical perspective, warning signs abound that the current bull market is on its last legs.

Reading the tea leaves

The Dow Jones Industrial Average ($INDU) has been tracing out a dangerous-looking "head-and-shoulders" reversal top over the past few months that could put late-2011 lows back in play. That would be worth a 21% drop from current levels -- the definition of a bear market.


A head-and-shoulders pattern often signals a market poised to weaken, perhaps substantially. The Dow's October peak is the head of the pattern. The shoulders came in May and early December.

On price alone, there is also the long-term head-and-shoulders pattern the Standard & Poor's 500 Index ($INX) is tracing that dates to the late 1990s. Theoretically, technical analysts would argue, the chart is saying the S&P 500 could fall to zero. The odds are remote, but merely a return to the early 2009 low would be a 53% drop from here.

There's more. Over the past two weeks, breadth has been narrowing as buyers find fewer stocks that interest them at these levels. Options traders are moving into put-option protection, pushing the CBOE Market Volatility Index ($VIX) up dramatically. Inflation expectations are falling as expectations for economic growth and the efficacy of a Fed stimulus are rolled back. And "safe haven" assets, like the U.S. dollar and Treasury bonds, are strengthening.

To be sure, there will be temporarily relief rallies along the way -- such as the one we’re seeing this week. Flurries of excitement will greet signs of compromise in Washington over fiscal issues. But there are bigger issues in play. Besides, even if Democrats and Republicans come to an agreement, that means only that they've found a mutually tolerable level of economic damage to dole out.

For conservative investors, the best option at this point seems to be pulling out of stocks and parking their money in cash and Treasurys to wait out the storm. For the more aggressive and nimble, there are profits to be had betting against key cyclical groups (like energy) while leveraging exposure to safe-haven trades.

Examples, already added to my Edge Letter Sample Portfolio, include the Direxion Daily Energy Bear 3x (ERY) and the Direxion Daily 20+ Year Treasury Bull 3x (TMF) exchange-traded funds. Other, less-leveraged, funds include ProShares UltraShort Oil & Gas (DUG) and iShares Barclays 20+ Year Treasury Bond (TLT).

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It's unclear if this will be a multimonth pullback or if the weakness will run into 2014. It depends on whether Washington can tackle its long-term budget challenges related to out-of-control health care spending and underfunded entitlement programs in a quick, minimally dramatic way.

The way things are going, with the partisan warriors armoring up for a fight -- not only on issues like taxation and Medicare but also gun control and contraceptives -- I'm not hopeful.

Be sure to check out Anthony's new money management service, Mirhaydari Capital Management, and his investment newsletter, the Edge. A free, two-week trial subscription to the newsletter has been extended to MSN Money readers. Click here to sign up. Mirhaydari can be contacted at and followed on Twitter at @EdgeLetter. You can view his current stock picks here. Feel free to comment below.