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Investor Psychology

How to Spot a Bear Market

By Elliott H. Gue, on Feb. 16, 2015

This week, the S&P 500 breached 2,100 and hit an all-time high. All told, the index has delivered an impressive total return of 250 percent since it bottomed on March 6, 2009.

But the duration of the current rally and other factors have elevated the risk of a sizavle pullback.

The S&P 500 last endured a correction of more than 20 percent in 2011—177 weeks ago, to be exact. With the average bull market (defined as periods between pullbacks of this magnitude) stretching for 172 weeks, this rally looks ripe in the tooth.

The odds of a significant correction look even greater when you consider that only three of the 12 bull markets that have occurred since 1960 lasted for more than 200 weeks.

Several other indicators suggest that the risk of the market suffering a pullback of at least 20 percent is on the rise.

Don’t take this warning to mean that it’s time to run for the hills and liquidate your portfolio or that we’re on the verge of another financial crisis. In fact, we wouldn’t be surprised if the S&P 500 were to continue to hit new highs in the first half of 2015.

But investing in the latter innings of a major bull market involves higher risks; you need a solid game plan to protect your portfolio, income and gains when market conditions deteriorate.

Now is the time to focus on potential risks embedded in your portfolio. It’s definitely not the time to buy the dips in energy and other vulnerable sectors.

Investors should remember that bear markets tend to be shorter and more violent than bull markets.

The S&P 500 hit a record high in October 2007; 12 months later, the broader market had given up all its gains from the four-year bull market. Likewise, the Nasdaq gave back all its gains racked up during the 1995-2000 bull market in about 2.5 years.

Don’t risk giving up your hard-won gains. Here are two warning signs we’re watching.

Correction Watch: A Weakening US Economy

As we explained in the Nov. 3, 2014, installment of Big Picture, This Old Bull Still Has Legs, bear markets that coincide with a recession tend to be more severe and last longer than those that occur while the economy continues grow.

Investors should monitor a few basic economic indicators to evaluate the risk of a potential recession.

A welter of economic data relating to the US economy is released each week, providing ample fodder to support just about any prediction you care to make—no wonder the financial media discusses these indicators ad nauseam.

Some armchair economists and pundits make the mistake of reading too much into one or two isolated data points.

For example, a shortfall in the widely watched payrolls data released by the US Bureau of Labor Statistics each month can send the market into a tailspin. However, this data point includes seasonal adjustments and is subject to significant revisions in ensuing months.

Employment data provides meaningful insight into the health of the US economy, but investors shouldn’t panic if these initial numbers fall short of expectations for a month or two.

Human beings naturally seek validation of their market beliefs and positions; to avoid this costly confirmation bias, try to remove as much emotion from the equation as possible. Focus on a handful of time-tested economic indicators and monitor them for signs of trouble.

One of my favorite indicators is the Conference Board’s US Leading Economic Index (LEI), a composite of 10 data series that historically have turned lower months before a recession hits or before the economy expands.

One of the simplest and most useful ways to analyze this data set is to track the LEI’s monthly movements; four consecutive months where the index is flat or down historically have provided advance warning of an impending recession.

LEI Table

According to the National Bureau of Economic Research’s (NBER) Business Cycle Dating Committee, the US has experienced seven recessions since 1962, all of which were flagged by this simple analysis about three to six months in advance—enough of a head start for investors to avoid the worst of the selloff.

This indicator isn’t perfect. For example, the LEI was three months behind the curve for the mild recession that struck in 1990 and flashed a warning signal in 1966, even though the economy never contracted.

Right now, the LEI doesn’t suggest that a major contraction is imminent; the most recent negative sequential change in this forward-looking index occurred in January 2014, an anomaly spurred by unseasonably cold winter weather.

External factors pose the biggest risk to the US economy this year. The greenback has strengthened dramatically since mid-2014, pushing the trade-weighted US Dollar Index, which measures the currency’s value relative to a basket of its peers, to its highest level in more than a decade.

(Click graph to enlarge.)BDXY Index

During fourth-quarter earnings season, several large US companies cited this trend as a risk to future profits because Uncle Buck’s strength relative to other currencies makes American goods more expensive abroad. In addition, a strong US dollar reduces the value of revenue booked in international currencies.

Economic data in most large economies outside the US remain weak.

Consensus expectations call for the eurozone’s gross domestic product to grow by 1.2 percent in 2015, while France and Italy could slip into recession.

Emerging markets, long the engine of global growth, also look troubled.

Chinese economic growth has slowed over the past 12 months, and the country’s widely watched Purchasing Managers Index recently slipped below 50, a sign of more downside to come.

Meanwhile, Russia’s economy likely will shrink by at least 4 percent this year because of the collapse in energy prices. Brazil’s economy is stagnant at best.

The Bloomberg consensus estimate calls for the US economy to expand by more than 3 percent this year, an improvement from the 2.4 percent growth rate registered in 2014.

At this point, the US looks on track to live up to these expectations. However, we see downside risk from global weakness the US economy, despite its size and competitiveness, doesn’t exist in a vacuum.

Correction Watch: Narrowing Leadership

The number of stocks pushing to new highs tends to narrow in the latter stages of a bull market, a phenomenon that’s characterized by a series of higher highs and higher lows.

(Click graph to enlarge.)PX Index (S&P 500 Index)  Daily 2015-02-17 21-55-23

Consider the end of the S&P 500’s 2003-07 bull run. In late February 2007, the index peaked near 1,460 before suffering a 7 percent correction that lasted into mid-March.

The next rally took the S&P 500 to a new high of about 1,555 in mid-July, while a 12 percent correction that ran through mid-August left the index at a higher level than its March 2007 low.

Then, the S&P 500 began what proved to be the final rally of the 2003-07 bull market, reaching a marginal new high of 1,576 in mid-October—about 20 points above the July top.

Although the S&P 500 met the definition of a bull market by making higher highs and higher lows, the number of stocks pushing the index higher had shrunk considerably over this period. In fact, by the time the S&P 500 hit fresh highs in October 2007, almost half the names traded on the New York Stock Exchange (NYSE) were in a downward trend.

Check out this graph tracking the percentage of all NYSE-listed equities that trade above their-200-day moving average–a sign that  a stock is in an uptrend.

(Click graph to enlarge.)Portion of Stocks Above 200-day

When the S&P 500 rallied to about 1,460 in February 2007, a healthy 84 percent of NYSE-listed stocks traded above their 200-day moving average. At the S&P 500’s July 2007 high, about 63 percent of NYSE stocks fell into this category.

With fewer and fewer stocks pushing the S&P 500 higher as 2007 progressed, the index lacked the momentum to support higher highs.

This pattern occurs in virtually all bull market tops that have occurred in the postwar era.

History isn’t on the S&P 500’s side in 2015.

In 2014, the S&P 500 logged a high of about 1,850 in January before pulling back about 6 percent to its February low. The index rallied to 2,019 in September, but its mid-October low represented a retrenchment of about 10 percent. Earlier this week, the S&P 500 hit an all-time high.

But check out this graph tracking the number of NYSE-listed stocks trading above their 200-day moving average.

(Click graph to enlarge.)SPX PErcent Above 200-day -- 2013-15

In September 2014, only 60 percent of NYSE-traded stocks remained in an uptrend. Even more concerning, this market leadership narrowed to about 55 percent as the market made new highs in late 2014 and early 2015.

I recently made A Free Video Report highlighting other warning signs on our radar screen and three simple steps you can take to protect your portfolio in the coming bear market.

Click here to see Elliott Gue’s 3 Warning Signs

3-warning-signs-red

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