What Signals A Bear Market ?

Bear markets (BM) are painful. Since the 50s, US bear markets have resulted in an  average loss of 31% (most painful were Oct-07 at 57%, Mar-00 at 49% and Jan-73 at 48%).

Of course, timing the market is futile and doesn’t help the investor over the long run. It’s more important to have a clear view on the value of any financial asset and seize it when it trades with a margin of safety.

But understanding the market dynamics and the financial environment might be helpful, especially if you want to be able to take advantage of the next downturn.

Goldman Sachs published an in-depth report on the characteristics of bear markets and what signals investors should track to try and anticipate them.

Source: Goldman Sachs

Pattern of bear markets

Bear markets tend to evolve in different stage, with an initial fall from peak (9% on average that lasts 2.1 months), followed by a rebound of c8% over 3.6 months, right before the real drawdown that averages 32% over 12.9 months.

Intermediate bounce in market prices can be explained by a couple of factors: 1) bull market investors try to find a buying opportunity in the initial dip; 2) there is a lag of c5 months before EPS start to decline and confirm the market decline.

3 types of bear markets

This is GS’s classification:

« 1. Cyclical bear markets – typically a function of rising interest rates, impending recessions and falls in profits. They are a function of the economic cycle.

2. Event-driven bear markets – triggered by a one-off ‘shock’ that does not lead to a domestic recession (such as a war, oil price shock, EM crisis or technical market dislocation).

3. Structural bear market – triggered by structural imbalances and financial bubbles. Very often there is a ‘price’ shock such as deflation that follows. »

Source: Goldman Sachs
Source: Goldman Sachs

Bear markets and earnings

All bear markets are not equal when it comes to earnings. Event-driven BMs don’t experience the same level of EPS evolution as structural or cyclical BMs.

If you take out this type of BM, EPS on average decline by 17%. « Removing event-driven bear markets and looking at the entire decline around the bear market (taking into account that the precise timing of EPS decline differs in each cycle) gives an average EPS fall of 38%. This fall is similar to the average price fall in bear markets since the 1960s (excluding event-driven BMs) of 40%. »

Source: Goldman Sachs

Also prices start to fall 5 months before EPS does.

What triggered bear markets in the past

Source: Goldman Sachs

Anticipating bear markets

Source: Goldman Sachs

The list above is long. By testing some of the indicators, GS finds that 5 factors have more importance than others.

« The most common features of BMs are some combination of deteriorating growth momentum and tightening of policy at a time of high valuation. »

  1. unemployment: rising unemployment corroborates the risk of recession, but this indicator lags the equity market. Yet « the combination of cycle low unemployment and high valuations does tend to be followed by negative returns. »

  2. inflation: « rising inflation has been an important feature of the environment prior to BMs in the past. » Yet (again) the absence of inflation reduces the chances of tightening and therefore the risk of BMs.

  3. yield curve: « tighter monetary policy often leads to a flattening or even inverted yield curve. » Again, combined with high valuation, flat or inverted yield curve is a valuable indicator of BMs.

  4. ISM: it’s a classic leading indicator, which is useful when it starts to decline or deteriorate.

  5. Valuation: « high valuations are a feature of most bear market periods. Valuation is rarely a trigger for a market fall (…). But when other fundamental factors combine with valuation as a trigger, bear market risks are elevated. »

Source: Goldman Sachs

At close to 70%, « our aggregate Bear Market Risk Indicator shows the average of these factors.

Historically, when the Indicator rises above 60% it is a good signal to investors to turn cautious, or at the very least recognize that a correction followed by a rally is more likely to be followed by a bear market than when these indicators are low.

By the same token, when the Indicator is very low, below 40% (as was the case in 1975, 1982 and 2009), investors should see any market weakness as an opportunity to buy. »