Let’s face it. We all want to know when the next bear market will start. Fortunately, there is a way to know. There are actually many tools that will tell us exactly when the bear market starts. Of course, they all signal after the market turns.
Even though signals from some tools will come after the down turn is underway, these signals could still provide a profitable warning. And, it could be that early signals are dangerous to your wealth.
Early Can Be Devastating
Stocks can be on a sell signal well before the market turns down. The chart of the popular CAPE ratio is shown below to illustrate this point.
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Source: Dr. Robert Shiller
This CAPE ratio is the cyclically adjusted price to earnings (P/E) ratio developed by Nobel Prize winning economist Robert Shiller. It compares current prices to average earnings over the past 10 years adjusted for inflation. It’s intended to measure earnings over the course of an entire business cycle.
Shiller has collected data to calculate this metric back to 1871. The long term average is about 17. When the ratio is above 17, the stock market is considered to be overvalued. Readings below that long term average identify spots that should be ideal buying opportunities.
CAPE has identified some important market tops, including 1929, 1966 and 2000. In 1966, the market began a bear market that would last for 16 years. Stocks crashed after the peaks in 1929 and 2000. These example demonstrate that CAPE can be useful.
But, the stock market has been overvalued by this measure almost continuously since 1998. Getting out of stocks when the indicator was above average would have meant missing almost all of the bull market that has marked most of the past twenty years.
This shows that it can be costly to get out ahead of the top. It is tempting, but as the great economist John Maynard Keynes is supposed to have said, “markets can remain irrational longer than you can remain solvent.” Since irrational markets can provide large gains, that is not the time to be in cash necessarily.
Watch for the End With This Simple Timing Tool
Many investors have found it is still profitable to become defensive after the start of the bear market is apparent. They can use relatively simple tools to tell them when it is time to become more conservative. Among those simple tools is the 10 month moving average (MA).
Another noted economist, author of “Stocks for the Long Run” Dr. Jeremy Siegal, recommends using the 200 day MA to define the trend of the market. One of the world’s greatest traders agrees with this idea.
Tony Robbins interviewed Paul Tudor Jones in his book, “Money: Master the Game.” Jones told Robbins, “My metric for everything I look at is the 200-day moving average of closing prices. I’ve seen too many things go to zero, stocks and commodities.
The whole trick in investing is: “How do I keep from losing everything?” If you use the 200-day moving average rule, then you get out. You play defense, and you get out.”
This rule helped Jones avoid the October 1987 stock market crash. It also signaled before the 2008 market decline. The Dow Jones Industrials Average crossed below its 200 day MSA giving a sell signal in December 2007.
While it’s effective, the 200 day MA can require some effort to follow. Equally effective is the 10 month MA which requires updating just 12 times a year. Mebane Faber showed this in his paper, “A Quantitative Approach to Tactical Asset Allocation.”
He tested the 10 month MA from 1901 to 2012, a period of time that included the Great Depression, the financial crisis of 2008, the Internet bubble, a time of runaway inflation and times of deflation. It is a broad sample of economic and global changes.
His research shows that using the 10 month MA can reduce risk. He also found that this simple strategy beat the market over that time period. But, most importantly, it reduced risk.
Over that time, the S&P 500 delivered an average annual return of 9.3% to buy and hold investors. The worst year saw a loss of 44%. Selling when the price fell below the 10 month MA and buying back when the index crossed above the average led to an average gain of 10.2% a year and a worst year of 27%.
This simple strategy actually shows a gain in 1931 when the S&P 500 lost 43.9%. It gained 1.4%. The same pattern was seen in 2008 when the S&P 500 lost 36.8% and the strategy gained 1.3%.
The chart below shows the S&P 500 over the past 15 years.
The sell signal in 2007 was timely. It avoided the entire bear market. However, the entry signal came after the index rallied more than 30%. Now, that would have not mattered.
A buy and hold investor lost more than half their capital. An investor using this MA had most of their peak capital intact. They invested a large amount on the buy signal and accumulated greater wealth in the long run.
Let’s assume an investor has $1,000 when the sell signal was given in 2007. That investor would now have about $2,000.
The MA trader would have suffered some short term losses and been out of the market about 40% of the time. That $1,000 however, would have grown to more than $3,200.
Simply avoiding the losses would help an investor grow wealth quickly. So, the next time there’s a sell signal from the 200 day MA or the 10 month MA, it could be time to raise cash.
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