Many analysts have indicators that warn of a bear market. But many of these indicators don’t work as well as expected. The biggest problem with a bear market indicator is the potential for false signals. That’s honestly a problem with many of the widely followed tools.
Even the yield curve, one of the best predictors of a recession and a potential bear market is prone to this problem. Economists often joke that the yield curve has predicted twelve of the last six recessions. Even when the yield curve is right, the problem is that there is too much lead time.
And, that is a large problem for investors. One of the most significant problems an investor faces is missing out on bull market gains. This problem comes into sharp focus at the end of the bull market when stock market prices often rise sharply. Missing those gains can have a large impact on wealth.
Despite that risk, many analysts scream “bear” every chance they get. And, most of these indicators fail to help investors accumulate wealth.
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This Indicator Is Different
There are a few indicators that are useful. But before determining how useful the indicators are, it could be best to define what makes a bear market indicator useful. Some simple requirements are that:
- The indicator should signal when significant market declines develop.
- The indicator should avoid false signals to the maximum extent possible.
- The indicator should give rare signals since bear markets are rare events.
With those requirements in mind, consider the chart shown below. It excludes the recent market action to focus on the historical record.
This is a chart of the S&P 500 index and uses monthly data. The indicator at the bottom of the chart uses red to highlight sell signals and green for buy signals. In nearly twenty years, there were just four periods with sell signals. Over that time, there were two bear markets under the standard definition.
The most popular definition according to thebalance.com, “a bear market is when the price of an investment falls over time. It begins after prices have fallen 20 percent or more from their 52-week high.”
Under that definition, the Dow Jones Industrial Average decline of 19.3% in 2011 is not a bear market. While many analysts will justify its exclusion, many individual investors might realize they suffered large losses at the time and it seems like a bear market.
There are other definitions. One used by many professional investment analysts is the one developed by Ned Davis Research, a well respected firm. Their definition of a bear market is:
“a 30% drop in the Dow Jones Industrial Average after 50 calendar days or a 13% decline after 145 calendar days. Reversals of 30% in the Value Line Geometric Index also qualify.”
Under this definition, the declines shown in 2011 and 2015 in the chart above qualify. Those were periods when the indicator gave a sell signal. The other sell signals were given in the bear markets that began in 2000 and 2008.
The Indicator to Monitor
The next chart updates the chart shown above to include the most recent market action.
A dashed blue line notes where the sell signal was given. Notice it did not occur right at the top. That is important because the large gains that often accompany a top in a bull market are worth pursuing. The sell signal did come close to the top.
Following that sell signal would have avoided the bulk of the decline that is now underway. While analysts debate whether or not an official bear market began in October, this indicator would have warned that it was time to sell rather than being time to debate.
The next chart does show a potential problem with this indicator. Buy signals are highlighted with vertical dashed lines.
The signals may come late for many investors. This is not an unexpected outcome. In general, asymmetric signals often work best in the financial markets because the emotional responses of many investors differ at tops and bottoms.
Because of those differences, there is no reason to expect buy signals to simply be the inverse of a sell signal. Because of those differences, it should actually be expected that different tools are needed to time buys and sells.
That means this indicator should be used to time sells and right now it is advising extreme caution in the stock market.
Despite the power behind this indicator, and the charts above do show how important it can be to follow this indicator, the indicator is actually quite common. The bottom of the charts shows a simple MACD indicator.
This crash alert indicator or bear market timing tool is available for free at dozens of web sites. The difference is shown here and how it is widely used is in the time frame shown in the chart. MACD works best on a monthly chart.
Many investors will try to apply indicators like this to daily charts or perhaps weekly charts. The difficulty with that approach is that there are a large number of signals. It can be difficult to overcome trading costs when there are too many signals.
The monthly chart avoids that with just five signals in twenty years. And each signal was followed by a steep decline.
MACD can be a useful tool for investors. But many individuals discover that they are not able to complete the required amount of research to time buys and sells because that can take an extended amount of time and they have other personal and professional commitments competing for their time.
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