Raul Elizalde - Tuesday, October 18, 2011
Most rational people would not load up on aggressive growth stocks if they knew that they were in the middle of a bear market. But how would they know?
Telling apart a bear market from a bull market has to do with investment horizons. For example, a rally started on October 4th and propelled the S&P500 more than 13% in less than two weeks. Somewhere, a day trader probably exclaimed that markets were “on fire.” But investors who only open their statements once a quarter most likely didn’t feel that way, since the S&P 500 closed the third quarter lower than the second, and the second lower than the first. While the trader wanted to be all-in, the investor probably wished he wasn’t.
This is not a mere statement of the obvious. Since last August, stocks have swung wildly within a 12% range and dipped briefly into an “official” bear market upon registering a 20% decline from the previous top – just before the 13% rally. Sentiment fluctuated accordingly, leaving most investors confused as to whether days when the market plunged represented an opportunity to buy or a glimpse into the abyss, or whether strong climbs were a golden opportunity to exit at relatively good levels or signs that the bull market train was leaving town. Emotional rollercoasters like these can easily distort an investor’s time frame perspective.
While it is impossible to know where the market is heading next, it is possible to say where the market actually is. One can make a strong case that the stock market is now in bear territory by using a simple model. How long this bear market could last nobody knows, but the last 20 years suggest that stock markets can stay in bear or bull modes for quite a while.
Our model labels the market “bull” if stocks are above their one-year average and the average is climbing. When both conditions are reversed, the market is labeled as “bear.” A change in one condition gives notice that the market may change from “bull” to “bear” or vice versa when the remaining factor switches too. This simple model may not be useful as a predictor, but it describes well what kind of market investors are in. At least this is useful for those investors that can look at periods measured in quarters, not days.
This model accurately labels the massive bull climb from early 1991 to early 2001, the following bear market after the dot-com crash, the credit-fueled bull market of the mid-2000s, the recent financial market bear market, and the most recent 2009-2011 bull recovery.
One period that stands out is after the 1994 Mexican devaluation, when markets lost direction for almost a full year and the model switched back and forth. And in 1998 the stock market tumbled because of the Asian financial crisis and the model generated a short-lived “bear” alarm. Apart from these two periods, however, conditions are identified sharply and correctly by the model. And according to it, the S&P 500 entered a new “bear” phase in early August.
That this might be the case is suggested by the fact that the market climbed so strongly in the last two weeks. Since 1973 the average daily return in up-days during bull markets is about 0.65%, but during bear markets, stocks go up more in up-days, by an average of 1.02%.
Since 2003, the difference has grown larger. The S&P500 now goes up by an average of 0.59% in up-days during bull markets, and an eye-popping 1.51% in up-days during bear markets. This is consistent with the known fact that shaky markets are more volatile. It should make investors think twice before celebrating strong up-days like the ones we had in recent weeks.
It’s possible that the current “bear” mode could be short-lived. Europe could find a way to save its banks and reduce its debt, albeit at the cost of economic growth (see our newsletter The Elusive Grand Solution, 9/30/11). The US could find political consensus to improve its long-term fiscal problems, which are far from insurmountable, while allowing whatever economic “green shoots” to flourish by easing short-term fiscal concerns. And China could prevent its increasingly unproductive investments in infrastructure from causing a hard landing.
But these challenges are unlikely to be dealt with swiftly. European leaders can’t move quickly when solutions depend on huge structural changes such as changing treaties, building new supra-national entities, or agreeing on pan-European actions affecting national banking systems. Nor will the global public and private debt excesses of the past be purged overnight. And economies don’t spring to life or get restructured in a matter of weeks. It’s not that it can’t be done; it’s that it will take time.
If we are right on this, our model may remain in “bear” mode for some time. This means that keeping portfolios defensive and light on stocks may be the right strategy, while taking the plunge right now would be foremost and mainly a leap of faith.
Raul Elizalde | raul@pathfinancial.net
©2011 Path Financial LLC
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