Investing Advice: Signs Point to a Bear Market Soon

Posted On January 4, 2018 2:33 pm

The stock market has started 2018 very strong out of the gate, with the major indices jumping an average of 3.1% and hitting all-time highs on three consecutive days. Be that as it may, our investing advice today is to treat this environment with some caution.

To be sure, there are many valid reasons for the positive price performance and investors’ overall bullish outlook. Tax reform is expected to boost the S&P 500’s earnings by 12%, retail sales over the holiday season showed the best increase in over four years, and other central banks are still keeping interest rates artificially low.

All of this had led to nearly euphoric behavior. Throw in the historically low VIX, and the bubble-like speculation in some corners like cryptocurrency, and we might have, as Jeremy Grantham recently called for, the makings of a blow-off top.

While some of these contrary sentiment indicators calling for a top can be squishy, a recent article from ZeroHedge relies on firmer economic data to suggest that indicators preceding a bear market are growing.

Indeed, their report now shows that 11 of 19 gauges that lead to a bear market have now been triggered.  Granted, one of the most important, a third consecutive downward revision in earnings estimates, might have now been reversed in the days following the passage of tax reform.

But as the table shows, ten other thresholds have still been crossed.

To wit:

  • Bear markets have always been preceded by the Fed hiking rates by at least 75bp from the cycle trough
  • Minimum returns in the last 12m of a bull market have been 11%
  • Minimum returns in the last 24m of a bull market have been 30%
  • 9m price return (top decile) vs. S&P 500 equalweight index
  • Consensus projected long-term growth (top decile) vs. S&P 500 equalweight index
  • We have yet to see a bear market when the 100 level had not been breached in the prior 24m
  • Similarly, we have yet to see a bear market when the 20 level had not been breached in the prior 6m
  • Companies beating on both EPS & Sales outperformed the S&P 500 by less than 1ppt within the last three quarters
  • While not always a major change, aggregate growth expectations tend to rise within the last 18m of bull markets
  • Trailing PE + CPI y/y% >20 in the prior 12m
  • Based on 1- and 3-month estimate revision trends; see footnote for more detail

And here are the eight indicators that have yet to ring the proverbial bell.

  • Each of the last three bear markets has started when a net positive % of banks were tightening C&I lending standards
  • Companies with S&P Quality ratings of B or lower outperform stocks rated B+ or higher
  • In the preceding 12m of all but one (1961) bull market peak, the market has pulled back by 5%+ at least once
  • Forward 12m earnings yield (top decile) vs. S&P 500 equalweight index
  • A contrarian measure of sell side equity optimism; sell signal trigged in the prior 6m
  • A contrarian measure of buy side optimism
  • Does not always lead or catch every peak and all but one inversion (1970) has coincided with a bear market within 24m
  • Market peaks have come after the VIX >20 at some point in the prior 3m historical basis, the minimum threshold for a bear market onset was no less than 80% of the signposts “flashing red.”

Which means that the bear market may or may not be imminent. So, what investing advice do we have for trading in this clearly overvalued market? Well, as Bank of America concedes, we are in a stage when fundamentals no longer matter. What does?

Momentum. And right now that is going nowhere but higher.

 Related: Walmart Has Bounced Back From Its Problems With Ease, and Here’s Why

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About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.

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