It’s coming. We all know the end of the bull market will arrive one day. The obvious problem is that we don’t know when that day will come. The less obvious, but equally significant problem is that becoming bearish too soon can be costly.
Stocks became overvalued by some measures by 1996. In December of that year, then-Chairman of the Federal Reserve Alan Greenspan famously asked, “But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?” His concern that stock market trading prices reflected irrational exuberance was sound, based on the data at that time.
What Greenspan didn’t know was that prices would rise sharply for more than three years. The large cap S&P 500 index would gain more than 70% before peaking. The NASDAQ 100, the index at the center of the bubble, would gain 480% over that time. Missing these gains would have meant missing a once in a generation opportunity to accumulate wealth.
Bears will take solace in the fact that prices did dip below the level they were at when Greenspan warned of irrational exuberance. Briefly, during the bear markets that began in 2000 and 2008, prices would return to those levels before rebounding and reaching new highs. Buy and hold investors would have fared well, over time assuming they did not need access to their money during the bear markets that lasted for several years. Market timers able to sidestep the worst of the declines in the bear markets would have done even better.
While no timing tool is perfect, there are some techniques traders and even investors with longer time horizons could have used to avoid losses and to get back when the new bull market began.
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A popular timing tool is the 10-month moving average (MA). The 10-month MA is similar to the 200-day MA but uses monthly data. The value of using less frequent data is that there will be less false signals. The 200-day MA will suffer from a number of small trades that last just a few days. The 10-month MA is calculated just once a month and will therefore give fewer signals.
The chart below shows how the 10-month MA would have provided sell signals near the top in 2000 and again in 2008. The chart consists of three panels. The 2000 market top is shown in the panel on the left side of the figure. The center panel shows the 2008 market top. The panel on the right shows the current market.
This indicator is not perfect as we noted earlier. In 1999, it would have provided a false signal as highlighted in the chart. The sell signal was quickly reversed one month later. That would have allowed investors to enjoy additional gains in the bull market before the ultimate top and subsequent sell signal again warned of a decline.
The 10-month MA provides surprisingly timely sell signals. In 2000, the sell signal occurred just 8.1% below the stock market’s top. In 2008, the signal was given when prices were only 6.5% below the bull market high.
There was also a sell signal in 2016, visible in the panel on the right. This period, from August 2015 until February 2016, included two sharp sell offs. Because the index did not fall by 20% it is not an official bear market. However, investors who turned bearish during this time would have been rewarded for their position since the selling was fast and price declines were steep.
One advantage of an objective trading tool like the 10-month MA is that it will also provide a buy signal. After prices turn up, there will be a close above the MA, signaling a new bull market. This solves a significant problem for many investors. Even investors who move to the sidelines and miss a bear market are faced with the decision of getting back into the market. Some miss the bulk of a bull market because they keep believing the decline will resume. A simple tool like the 10-month MA defines when an investor will turn bullish and avoids this problem.
A simple analysis of a chart can also be useful. The next chart shows the price action as a black line. The red line marks the highest high in the past 13 weeks. We use 13 weeks for this technique because that is about three months. Using a three month look-back period allows us to see the fundamental trend of the market since that includes one earnings season, the time period when companies deliver quarterly results. If the quarterly financial performance is bullish, we should expect stock prices to rise. When financial performance fails to meet expectations, or is bearish, we should expect stock prices to fall. The technique shown in this chart captures that information.
Bullish price action is simple to define. It is a period of rising prices. Adding a little more complexity to that definition, bullish trends exist in the market when prices are reaching new highs. The indicator shows the highest high of the past 13 weeks. When prices are rising, the indicator should be moving up. When a new downtrend emerges, the indicator will fall. The sell signal comes when the indicator turns down.
The chart shows the beginning of the 2008 bear market. The sell signal, a decline in the highest high for the past 13 weeks, came 11% below the all-time highly. This was not as timely as the sell signal from the 10-month MA. But, this signal would develop on a weekly chart and could be more timely in the future.
That describes another problem all investors face. We have history as a guide in making decisions but we never know which indicator will be most useful in the future. We don’t know if the 13-week new high indicator or the 10-month MA will deliver a more timely sell signal when the next bear market begins. Likewise, we don’t know which indicator will provide the more timely buy signal at the end of that bear market.
Since there is no way to know which indicator will be best, it could be best to monitor a few indicators. In this case, once a week, investors can check if the 13-week new high indicator has turned down. Once a month, they can determine the direction of the trend using the 10-month MA. Conservative investors can take action to preserve capital when either indicator gives a sell signal. More aggressive investors, those willing to accept more risk of loss, can wait to act until both indicators are on sell signals. This will minimize the risk of a whipsaw trade but will delay action, potentially risking large losses and potentially delaying entry to a new bull market until months after the trend has reversed.
Neither indicator will provide a signal before the down trend emerges. This allows investors to participate in the bull market for as long as possible. Neither signal will be perfect. There will be whipsaw trades and there will be losing trades. But, either indicator can be used in a subjective manner to provide timely sell signals near tops and timely buy signals near bottoms.