At any given point in time there is always a debate concerning this or that. Are we in a bull market, are the markets peaking? Are bonds in a bubble? The final arbiter of these questions is always price. Price determines whether the bears or the bulls are winning on any investment question. Simply looking at where prices are relative to a long term moving average can help filter out the noise and answer some of these questions.
Bull and Bear Market Status
Using the 12-month moving average (12-Mo MA) for trend identification is a helpful tool in determining whether something is in a bull or bear market. As an example, let's look at six different charts and see if we can identify the overall trend. (Note: The main point in trend-following is whether a stock is above or below its moving average. Thus, the idea of a false breakout or breakdown—that is, a temporary move above or below a moving average—will sometimes occur. However, determining whether this is indicative of a market transition or merely temporary is demonstrated via market breadth, which I discuss later.)
US Stocks (SPY – S&P 500 SPDRs) = Bull
Source: StockCharts.com
US Bond Market (IEF – iShares Barclays 7-10 Year Treasury Bond Fund) = Bear
Source: StockCharts.com
Commodities (DBC – PowerShares DB Commodity Index Tracking Fund) = Bull
Source: StockCharts.com
Emerging Market Stocks (EEM – iShares MSCI Emerging Markets Index) = Bull
Source: StockCharts.com
Real Estate (VNQ - Vanguard REIT ETF) = Bull
Source: StockCharts.com
Gold (GLD – SPDR Gold Trust) = Bull
Source: StockCharts.com
Using the 12-Mo MA as a bull or bear market criteria, both US (SPY) and emerging stock (EEM) markets are in bull markets, as are US real estate (VNQ), commodities (DBC), and gold (GLD), while the US Treasury bond market (IEF) is the only one in a bear market. One of the most famous investing maxims out there is “don’t fight the tape.” Going against the grain is a fool’s errand as being able to call market tops and market bottoms consistently is not an easy feat but rather staying in harmony with the trend (with the trend identified using the 12-Mo MA) is easy for anyone to do.
Watch the Trees
Now, once we have identified the direction of the trend, it is important to gauge whether or not an actual transition from bull to bear or vice versa is taking place. We refer to this as the health of the trend, which is measured using market breadth—a measure of participation by individual stocks in a market’s advance or decline. Healthy markets are characterized by a large percentage of stocks advancing while poor markets are characterized by weak participation. It is important to understand that bull market peaks and bear market bottoms are often complex formations that do not occur overnight. Peaks occur as more and more stocks roll over into individual bear markets. Bottoms occur as fewer and fewer stocks are declining and eventually enough begin to rise to lift the stock market averages upward. Breadth is how we measure this process.
One particluar measure of breadth is using the 52-week new highs and lows data. If the bull market's advance is healthy then there should be a strong number of stocks making new 52-week highs while a bull market transitioning to a bear market should see a rising percentage of stocks making new 52-week lows.
Looking at the S&P 500 yesterday, when the market made a new 52-week high, there were 45 stocks within the S&P 500 that also made new highs while there were 0 stocks making new 52-week lows. While only 9% of the stocks within the S&P 500 were making new 52-week highs, there was 0% making new lows. If the S&P 500 was on the verge of a bull market peak we should see the percentage making new lows expanding, not sitting at 0%! Looking at the Dow Jones Industrial Average, 0% of stocks within the index were making new 52-week lows yesterday, not the stuff of bull market peaks in the making.
It is not surprising that the stock market isn't showing any sign of a major impending top as the economy is currently expanding at a decent clip. Returning back to the idea of deteriorating or improving breath as a useful tool in identifying transitions in the market, let's look at economic breadth to create a recession probability model. As long as the majority of economic indicators are improving, the chance of a recession is low. However, heightened recession risk occurs when more and more of the indicators are deteriorating. Looking at my recession model currently shows only a 15.25% chance of a recession beginning over the next 3-6 months as 84.75% of the indicators I track are expanding. A yellow flag occurs when the indicator moves north of 20% and a red flag occurs when the 30% level is breached. Going back over the last three decades, readings that rise above the 20% threshold have led to a recession in 5 out of 6 occurrences, with the 1989 spike providing the only false signal.
Source: Bloomberg
The Bulls have the Reins
Rather than driving oneself mad trying to factor thousands of pieces of information in order to predict the direction of the stock market, I argue a simple trend-following system. As I have shown, using the 12-Mo MA, the only trend that is currently bearish is the US Treasury bond market while the US stock market is still in bull mode. Moreover, looking at breadth to determine the health of the trend shows no significant deterioration in the US stock market as there are no stocks within the S&P 500 nor the Dow Jones Industrial Average hitting new 52-week lows as is often seen at bull market peaks. The breadth readings of the stock market are in agreement with the breadth readings of the economy as the bulk of economic indicators are rising (84.75%) and as long as breadth remains healthy the stock market should continue to rise and the economy should continue to expand. In short, the bulls have the reins for now.
