For decades, investors have sought out methods to detect oncoming bear markets. With this current bull market now in its 5th year the subject has become even more topical – “Has the bull market still got legs?” is a question pondered every day by millions of investors. In this research note, we cover seven of ten reliable Bear Market warning signs we use and how they can be combined into a simple stock market exposure allocation strategy.
But first, let’s define a “Bear Market”. A Bear market is a market condition in which the prices of securities are falling, and widespread pessimism causes the negative sentiment to be self-sustaining. As investors anticipate losses in a bear market and selling continues, pessimism only grows. Although figures can vary, for many, a downturn of 20% or more in multiple broad market indexes over at least a two-month period, is considered an entry into a bear market. In most instances (but not all) an economic recession will accompany (even trigger) a Bear market. A Bear market should not be confused with a correction, which is a short-term trend that has a duration of less than two months. Although the Crash of ’87 was a major correction, it technically was not a bear market since the stock markets recovered shortly afterwards.
Our endeavor in this exercise is what we term “Investment Market Timing” which is to avoid major, extended stock market corrections, most often accompanied by recessions, in order to reduce brutal buy-and-hold draw-downs and outperform the buy & hold strategy on an absolute and risk-adjusted return basis, deploying as few trading transactions as possible.
Using robust models to detect for probability of oncoming economic recession is thus one method to avoid bear markets, but although this will allow you to dodge the worst damage, a recession rarely encompasses all of and overlaps perfectly with, the entire stock market correction. In general, the use of econometric models will allow you to match closely with some stock market peaks (see “Recession : Just how much warning is useful anyway?“) but will sorely lag with the ideal stock market re-entry points in many cases, since stock markets rebound way before the recession is over. Furthermore, in many instances a recession will not even lead to a bear market correction and in even more instances, a bear market correction will not lead to a recession! There is the well known jibe on Wall Street: “The Stock market has predicted 9 of the last 5 recessions” to illustrate this point. Nonetheless, a decent long-run investment return sans the gut-wrenching draw-downs of most bear markets can be achieved through recession probability monitoring, as described in our Recession Forecasting Ensemble & Investment Timing research note.
(Listen to: "Dwaine Van Vuuren: No Recession in Sight for the US")
You can make substantial improvements in your Bear Market detection methodology, and your subsequent stock market investment timing endeavors, using factors derived directly from the stock market itself. These include, but are not limited to, rate of change, moving averages and other technical indicators, market breadth indicators and even seasonal factors. We deploy ten of these, seven of which we will demonstrate in this research note. Before we continue, it is important to understand that major stock market peaks that precede bear markets take a long time to form. In fact, major stock market top formations are a rather drawn-out process taking up to 12 months in some cases. Major stock market top-detection techniques are diametrically opposed to the techniques used for detecting major stock market bottoms, which are violent rapid reversals that catch most people by surprise. To the astute observer, warnings of impending bear markets thus start making themselves known way before the bear market correction ensues.
We will examine bear market detection using seven methods drawn from a diverse array of indicators that have robust long-term (multi-decade, multi-business cycle) track records. The reason we deploy a diverse array of methods is that no single technical, econometric, breadth, sentiment or seasonal indicator is infallible and 100% correct 100% of the time. The deployment of a battery of indicators into a consensus model reduces the risks of over-reliance on any single factor. The consensus composite we build from these seven factors is dubbed the “Composite Market Health Index, or CMHI for short. For each of the charts we show below, we take the relevant indicator and standardize them to have a mean of zero and a variance of 1. This allows us to combine them into an equally weighted composite later.
Paw-Print One: Net New Highs
As the stock markets approach their major peak, more and more of their individual constituent stocks fall into their own little bear markets. Eventually with only a few large cap stocks left propping up the market rise, the overall index has to succumb to the weight of gravity of its constituent falling stocks and the bear market correction ensues. It is a remarkably little-known fact that on the day of the peak, less than 10% of an indexes’ constituent stocks will be printing new highs. Thus one way to detect the onset of a bear market is to track the percentage of shares in the index that are printing new long term highs. Many people prefer to use the 52-week highs to do this, but we deploy our own measurement based on less than 52 weeks and subtract new lows from new highs to achieve more timely results.
Paw-Print Two: Rising/Falling Trends
As the stock markets approach their ultimate top, shares get more and more expensive forcing savvy investors to deploy extreme selectivity in individual share selection to minimize their risks of overexposure to over-valued shares. Fewer and fewer stocks get chased by a growing pool of investors and the stock markets gains are driven by fewer and fewer stocks. We can measure for this by tracking the percentage of constituent stocks that are still in medium to long-term up-trends. When more stocks are in down-trends than are in up-trends for an extended period then extreme selectively is in play and we have our market top warning. You can use the % of stocks trading above their 200 day moving average as a quick and dirty calculation here but the metric we use is more optimized for timeliness and produces far fewer false positives.