There is a lot of confusion presently in the market place as participants grapple with a very important question, “Are we in a bull market correction or has a bear market started?” It goes without saying that the answer to the above question is vital. If this is a bull market correction, investors should be using market corrections to add to their equity portfolio. However, if this is a bear market, investors should be using rallies to sell into strength to build up cash and increase their defensive posture. So which is it? Are we in a bull market correction or bear market?
Long Term Trend Signals Suggest Bear Market
At present there are several long term sell signals for trend following indicators I monitor. That said movement to the upside will reverse a lot of these recent signals which is why I still think the market’s trend is a bit cloudy at this time. There are five key indicators I track to determine the long term trend for the stock market (S&P 500) and four of the five are presently flashing warning signs.
Two of the signals I track are the weekly 14 and 40 period exponentional moving averages (EMA) for the S&P 500 and the stock/bond ratio (S&P 500 to 10-Yr UST). I look for bearish or bullish crosses to mark turning points from a bull to bear market. This EMA system has worked beautifully over the past decade as it called the 2000 and 2007 tops and the 2003 and 2009 bottoms with no false signals. Given its track record the fact that both have now given sell signals should be of concern. The stock/bond EMA signal was given on July 2nd while the S&P 500 EMA sell signal occurred last Friday. While the 15 EMA is 2% below the 40 week EMA for the stock/bond ratio, the sell signal for the S&P 500 is hanging by a thread as the 15 week EMA comes in at 1089.44 while the 40 week EMA sits at 1090.41, so roughly one point separates the two moving averages and it would not take much to get a whipsaw back to a buy signal if the markets continues today’s advance. So, while both signals are currently flashing sell signals there is still the potential to get a whipsaw back towards a buy signal and I would want to see both 15 week EMAs 2% or more below the 40 week EMA to be confident that true sell signals have occurred.
Source: StockCharts.com
Another indicator I track is the health of the U.S. financial markets using my U.S. Financial Stress Index. The index measures the volatility of the money market, bond market, stock market, US Treasury market, and the currency markets with all five financial markets aggregated in an equally-weighted composite. When the index dips into negative territory it indicates financial markets are starting to act up as greater levels of risk are being priced into financial system, while levels in positive ground indicates a properly (normal) functioning financial market. The indicator moved into positive territory in January of this year after remaining negative since September 2007. For the third time in the past decade the indicator has fallen into negative territory, dipping below zero in late May. Since the July lows the index has since rebounded as there has been some healing in the equity, money market, bond market, and currency markets, while there has been some instability in the US Treasury market recently. Overall though, while there has been some improvement recently the index remains in negative territory, flashing a sell signal on the U.S. financial system.
Source: Bloomberg
A fourth indicator I monitor for identifying long term trends for asset classes is the price relative to its twelve month moving average (12-Mo MA). This indicator for the S&P 500 first flashed a sell signal in June that was later reversed in July and has reversed back again to a sell signal in August. While the indicator has been whipsawing over the last three months, it still has a proven track record as pointed out in a prior article ("When the market speaks, listen!"). As shown in that article, this risk management tool worked well in the 1970s secular bear market in which you would have been left with a profit of 123% versus a profit of 29.6% using a buy and hold approach. It performed even better in the present secular bear market that began in 2000 would have produced a profit of 200% versus a 29.8% loss using the buy and hold approach. Consequently, whipsaws or not it has paid to listen to this risk management tool and it is back to flashing a sell signal as of yesterday’s close.
Source: StockCharts.com
A fifth indicator I track is my modified version of the Coppock Curve. I use a different moving average system for buy and sell signals to help prevent whipsaws and sell signals are only valid if a buy signal has been given. A buy signal occurred on June 12th of last year and as of yet there has been no sell signal as the Coppock sell indicator has merely pulled back from lofty momentum levels.
Source: Bloomberg
Of the five trend indicators I follow there is only one on a buy signal, thus a weight-of-the-evidence approach suggests the trend is down and we are in a bear market. That said, given the ever present “Bernanke Put” it appears there is somewhat of a psychological floor under the market in which investors believe Bernanke will not let the market decline get out of hand. Thus, there is tremendous volatility in the markets which partly explains the recent whipsaws in the 12-Mo MA indicator and there is a significant possibility the S&P 500 15/40 week EMA may reverse back to a buy signal if the market continues to rally. We really have two scenarios here in which the actual case can only be known in hindsight. We could have put in a bull market top in April of this year with the first leg of the decline behind us (April to July correction), and we are now working off some of that oversold condition before undergoing the second leg down. Another possibility is that the weakness in the Euro that occurred around the market’s peak may now largely be over, and given the slide has been so great in the Euro much of the fiscal and monetary concerns may already be behind us, much like the temporary Asian Financial Crisis of 1997 that precipitated the 1998 world market correction. When most of the concern over Asian currencies had already been priced into the markets, they continued their advance into the 2000 top. Unless Europe really comes unglued then perhaps the stock markets can stabilize here and rally once more before topping out. To gauge which case is to be played out ahead looking at the character of the market will be crucial as certain characteristics mark bull markets from bear markets.
A Question of Character
Momentum indicators are great tools to gauge a markets character as bullish markets show higher upside momentum readings while bear markets show lower downside momentum. Basically, momentum shifts up for bull markets and down for bear markets and identify these shifts can help to determine whether the market trend is bearish or bullish.
Looking at different time frames identifies different trends. Using monthly numbers helps to figure out the long term trend while weekly numbers help with intermediate trends and daily numbers help identify short term trends. Using the 14 period monthly relative strength index (RSI) gives a good read on the markets long term trend as seen in the figure below that highlights readings below 50 (bear market territory). At 48.89 we are marginally in bear market territory but nothing for the bears to write home about as a whipsaw could easily occur. A dip further below 50 would cement the bears case but we aren’t there yet.
S&P 500 Monthly RSI
Source: StockCharts.com
Looking at the 14 period weekly RSI helps to shed light on the markets bullish or bearish character in which bullish markets typically see peaks occur north of 70 and bottoms occur around 40, while bearish markets see peaks around 60 and bottoms below 30. Given the recent decline bottom near 40 rather than the normal 30 zone the “character” of the market still resembles a bull market (see green line below from 2004-2007). Until the weekly RSI dips deeper below the neutral 50 level the bulls deserve the benefit of the doubt.
S&P 500 Weekly RSI
Source: StockCharts.com
Switching now to a short term view, we are roughly in the 30-50 bear market zone and have failed to appreciably move above 50 on any market rally, so it still appears that the short term momentum is bearish.
S&P 500 Daily RSI
Source: StockCharts.com
For the bulls to regain control the daily RSI needs to move above 50 which would cement a low on the weekly RSI in the 40 zone that marks bull market bottoms, which would then likely put the S&P 500 above 50 on the monthly RSI reading. However, if the markets roll over the daily RSI will likely remain below 50 followed by further deterioration on the weekly RSI below the 40 threshold for bull market bottoms, which would also push the monthly RSI deeper below bear market territory (<50). Watching the character of the RSI on multiple time frames should help investors determine the markets direction. For me the key will be the monthly RSI as I use that for long term trend identification, which at present is neutral as neither the bulls nor the bears have gained control of this market.
Another gauge used to judge the market’s character similar to RSI levels is how the market reacts to the lower 200 day Bollinger Band (200d BB). Just like how bull market corrections find support at the weekly RSI 40 level, bull market corrections find support at the lower 200d BB while bear markets continue to decline. This is demonstrated in the following charts of the 2000 and 2007 market tops. Notice that the S&P 500 dipped below its lower 200d BB several times late in 2000 and subsequent declines failed to hold the lower band as well. The first failed test for the last bear market came in January of 2008 with subsequent corrections throughout 2008 failing to hold the lower band. This was a shift in downside momentum like the RSI shift that marked the character of a bear market.
2000 TOP
Source: StockCharts.com
2007 TOP
Source: StockCharts.com
However, you can see in the great 1990-2000 bull market run that the lower 200d BB held throughout, even during the 1998 Asian Currency Crisis. It wasn’t until late 2000 that you had your first failed test of the lower band. Looking at the second figure below tells the same story in which the lower band held from 2003-2007.
1990-2000 Bull Market
Source: StockCharts.com
2003-2007 Bull Market
Source: StockCharts.com
The April to July correction was stopped dead in its tracks at the lower band and the August correction also was stopped dead in its tracks for what looks like the second successful test for the bull market that began in 2009. If the markets can rally from here then bull market conditions have prevailed and the bears need to go back to their caves. However, a market correction below the lower band (1030.16) for the S&P 500 and below the July lows near 1010 would be sending a double confirmation that the trend is unequivocally down and bear market rules apply in which rallies should be used for selling rather than corrections for buying.
Present Bull Market (Lower band comes in at 1030.16)
Source: StockCharts.com
Is it a bull or is it a bear? I would hold off making that call for now.
Simply looking at the major trend following indicators I track suggests that we are in a bear market as four of the five signals are flashing sells. However, two of them are barely negative and could easily switch to buy signals if the market heads just a little higher, leading to whipsaws and more frustration. Rather than attempting to get out in the first inning of a bear market, I would suggest taking a more moderate approach and wait for confirmation. You can be an incredibly successful investor without ever timing market tops and bottoms perfectly. In terms of a baseball game, just playing the second to eight innings or the third to seventh innings will keep you in the bulk of bull markets and out of the bulk of bear markets, and at the same time help you keep your sanity as you wouldn’t be whipsawed as much trying to be a perfect market timer.
In addition to tracking the five trend following indicators mentioned above I would suggest watching the 50 RSI level on the monthly 14 period for the S&P 500 in addition to the lower 200d BB. If the lower 200d BB fails to hold and the monthly 14-period RSI for the S&P 500 dips lower then we can be sure with further certainty that we are indeed in a bear market rather than something temporary like the 1998 Asian Currency Crisis or 2004 consolidation. The fact that 4 of my 5 trend following indicators are on sell signals does suggest having a below market exposure, but at the same time the character of the market (montly/weekly RSI, lower 200d BB support) resembles a bull market, and so with conflicting trends and character it is perhaps best to wait before becoming overly defensive. Thus, I’d hold off on making any major market calls at this juncture.
