With a dramatic decline in the stock market investors want to know, Are We Entering A Bear Market?
Let’s find out…
Since March 2009, this has been one of the most hated and unloved bull markets in history. If the bull market ended today, it would go down in history as the third longest and fourth most profitable bull market over the last 80 years!
With significant declines in the market last week, it has caused some of our indicators to wave warning flags.
Since the bull market began in March 2009, the S&P 500 has now had 57 one-day declines of 2% or more.
–Bespoke Investment Group
Of these 57 occurrences, Bespoke discovered that six months following the 2% down day the S&P 500 had positive returns 80.4% of the time. On average, the market was 3.48% higher six months later. Hopefully, that will be the case this time, but we are not going to rely simply on hope as a strategy. We prefer to base our investment decisions on the hard data our research efforts produce.
Let’s take a closer look…
Monitoring Our “LINE IN THE SAND” Market Indicators
To help show you what we are seeing, here is a chart of our “Hi/Lo Risk Gauge” (see chart below). With the big move to the downside last week, it pushed us into the warning zone with a reading of -12.07. Anytime this indicator moves below -5 we take notice.
From a near-term perspective, the technical picture of the market has clearly changed. As a result, our indicators have signaled a shift in bias towards a cautious or “bearish” view for the market in the near-term. (When I say “near-term” I am referring to the next 1 to 3 months.)
This type of signal does not indicate the need to make massive changes in strategy. What it does tell us is we need to have a heightened awareness and must closely monitor our longer-term indicators for any material change in direction. (We do this for you automatically within our managed account portfolios.)
Often I get asked by investors, “What would cause you to make a significant shift in strategy?”
The answer is a material change in our “Line in the Sand Indicators”. We use multiple indicators that help us move in or out of the market incrementally based on prevailing market conditions. As you know, we want to be in the market when conditions are favorable (according to our research) and conservative or even out of the market when our indicators suggest high-risk levels (such as a recession).
So let’s take a look at where three of our Line in the Sand Indicators are now…
The first Indicator is a price based indicator. We like to measure the S&P 500 index against its 20-month moving average to identify major bull and bear market trend changes. When the price (black line) is above the moving average (red line), the trend is bullish. When the price moves below the moving average, it is bearish. With last week’s market action, it has given us our first long-term bearish warning sign when the price closed below the moving average. This change is of great concern to us.
With this chart clearly raising a long-term warning flag, we want to look at other measures of the market to confirm that a long-term change in direction is taking place. (Notice the false signal during the 2011 EuroCrisis)
This next indicator measures all 500 companies that make up the S&P 500. It provides the percentage of companies trading above or below their 50 day moving average trend line (another useful way to measure bullish or bearish trends).
With a reading of 51.98, this chart does not yet confirm a bear market is upon us. Because the blue signal line (150 day moving average) is above the red horizontal line it continues to indicate this is likely a correction within a larger bull market trend (for now).
The third “line in the sand” chart we track measures the number of advancing stocks in relation to the number of declining stocks. With 2,000 companies trading on the New York Stock Exchange (NYSE), it is a very useful tool.
The Advance-Decline indicator is one of the most widely use measures of market participation (breadth). We feel it is a better tool to identify market strength and weakness than only looking at the day-to-day price action of the Dow Jones Industrial Average (DJIA) or the S&P 500 Index by themselves. Historically, when a bull market is ending, we can see evidence in the Advance-Decline line prior to the major indexes peaking due to the irrational exuberance often experienced near market tops.
This chart uses a 50-day moving average (blue line) as a signal of bullish or bearish bias when it is above (bullish) or below (bearish) the red dashed line (200 day moving average).
So what does all this mean for investors?
It means investors collective appetite for the market has changed. In recent history (last 3-4 years) when the market dropped 4.5% there have been buyers stepping in to “buy-the-dip” and bid the market higher. This time it has not happened (yet).
Fortunately for us, we know history. We understand that historically, markets average a 10% correction one time per year. We also know the market often gives us a 4-5% decline 3-4 times per year. Then once every three years or so we get a decline in the 20% range. It has been quite some time since we have gotten a correction in the magnitude of 10%.
With the DJIA down 10.1% through last Friday’s close and the S&P 500 down just 7.5% from their peaks earlier this year, this barely qualifies as a correction. The last 10% correction occurred in 2011 and based on the historical details I shared above, this current correction is long overdue.
We do not share this information with you to downplay the recent market events; rather we want to help keep things in perspective, so you do not get caught up in all of the hype.
Fortunately for us as investors, the market topping process often occurs over a 6-7 month period. As a result, our data will continue to provide a clearer picture in the coming weeks and months to confirm whether the ultimate peak of the current bull market has occurred.
So what should investors do going forward?
Have a plan and execute.
Investors need to have a plan of action. It is best to create your plan during calm markets, so when things get crazy, you just execute your plan.
This is what we are doing right now at Financial Analysts; we are executing our investment plan. We established our plan back in 2008 during the financial crisis and each day since we have focused on implementing our plan. As an example, this investor report is part of our plan for keeping everyone up to date on the latest market events.
Our risk-management plan consists of three key elements:
- Identify the prevailing market trends (is the market going up or down)
- Recognize pockets of relative strength and shift assets to where they are being treaded best
- Actively monitor each position and maintain a trailing stop-loss to help limit potentially catastrophic losses
So what happens next in the market?
Based on our experience and the fact that Friday’s market closed on the low for the day, we would expect the selling pressure could continue into Monday’s trading.
With this said, we are most interested in watching the market bounce that we expect to follow. How it plays out will give us further insight into the market. If we continue to see the health of our indicators deteriorate we will look to increase both our cash reserves and defensive investment allocations.
As we always say, if and when the fact change — so shall we!
The facts may very well be changing, so stay tuned for future investor updates. It is part of our plan to keep you up-to-date on what is happening in the market.
If you would like to discuss how our risk management techniques are applied to your accounts, or to go through your specific accounts in greater detail you can reach our office by dialing 919-787-7325 or by using the contact us page to reach one of our team members.
Please feel free to forward this message to others. It is our mission to help investors navigate changing market conditions.