“There’s simply no single answer to the question: What causes a bear market? … There is no fundamental indicator on its own, no technical indicator on its own, no single silver bullet, no nothing on its own perfectly predicting when a bear market will start.”
–Ken Fisher, The Only Three Questions That Count
A bear market is a fundamentally driven drop of approximately 20% or more over an extended period of time. We believe that, with thorough research and analysis, impending bear markets can be identified and some of the bear market decline can be avoided. Bear in mind, though, no one has consistently and correctly called every bear market in advance.
We think of bear markets starting in two ways—a “Wall of Worry” or a “Wallop”. The Wall refers to the idea that as bull markets mature, various investor fears become accepted and dispelled. These fears become bricks in the Wall that eventually lead to sky-high expectations and euphoria overtaking investors. A Wallop refers to an unexpected, immovable object that is large enough to knock off several percentage points off global gross domestic product (GDP).
Following are some indicators, or signs, that characterise negative fundamentals, euphoric investor sentiment and potential big negatives. While these indicators can be helpful, we don’t believe any single indicator alone is perfectly predictive of bear markets
|Weak Corporate Earnings/Profits||Are equity markets’ earnings degrading or falling for multiple successive quarters?|
|Inverted Yield Curve||The yield curve measures long-term interest rates compared to short-term interest rates. Are overnight interest rates higher than long-term, 10-year fixed interest yield rates? This could mean banks are not incentivized to lend and credit may tighten in the future, potentially causing business activity—and equities—to fall.|
|Faltering Revenue Growth||Earnings can be affected by outside factors; sales, less so.|
|High Inventories, Low Demand||Are business inventories piling up, while consumer demand seems to be tailing off?|
|Trend, Not Data Point||One data point isn’t sufficient evidence. The trend should recur for multiple readings and in multiple nations.|
Euphoric Investor Sentiment
|High Leveraged Buyout (LBO) Activity||Are equity markets’ earnings degrading or falling for multiple successive quarters?|
|Overpriced Initial Public Offerings (IPOs)||Are extremely low-quality IPOs—private companies going public to raise capital—flying off the shelves at sky-high valuations? Are companies going public solely for the sake of going public?|
|Rising Corporate Debt||Are businesses taking on more debt to raise capital, despite slowing or downward trending sales and earnings?|
|Uniformly Bullish Media||Is the media consistently showing optimism—and are those who were already optimistic now euphoric?|
|“It’s Different This Time”||Is there widespread discussion of how “It’s different this time”?|
|Euphoria||Is everyone talking about equities? Watching financial media instead of the football matches? Are investors flooding into equity collective investment schemes? Is your taxi driver giving you equity tips?|
A Wallop—Big Enough to Shave Several Trillion off Global Economic GDP
|Escalating Tariffs / Trade Wars||Are countries around the world constructing extreme barriers to trade?|
|Monetary Policy Errors||Has a major central bank made a severe policy error?|
|Regulatory Changes||Have there been massive changes in regulations or accounting rules that may adversely impact businesses?|
|Major Geopolitical Conflict||Is a major, global conflict likely to erupt?|
|Other Unknown Negative||Is there something else that can knock several trillion dollars off global economic GDP?|
A common misconception is that regional geopolitical conflicts are likely to cause bear markets. Note that, per the preceding table, a geopolitical conflict must be major and global in nature to end a bull market—a sustained period of rising equity prices. Smaller, regional conflicts typically aren’t powerful enough. For instance, the most recent bull market overcame innumerable fears, including those surrounding the Israel-Hamas conflict, Russian-Ukrainian crisis and North Korean missile tests—those fears simply became bricks in the “Wall of Worry” that bull market climbed. Even when global powers escalate a local war, it doesn’t usually derail a bull as long as the conflict remains geographically confined.
Although equities may fluctuate on uncertainty as a conflict begins, once the conflict is actually underway, the market typically digests and moves beyond it. Localised conflicts often don’t have the power or far-reaching economic impact to derail a global bull market. Thus, geopolitical conflicts rarely have a lasting impact on market direction. The one exception in modern history is the onset of World War II, which Walloped the ongoing bull market in 1937 when it became clear it was escalating into a global war. Still, equities bottomed in 1942, a full three years before the end of World War II. Equities can and do rise during periods of even significant armed conflict. A major, unexpected conflict inflicting global damage would be big enough to be a Wallop.
Exiting the equity market is one of the biggest investment risks you can make. If you are wrong and the market continues to climb, you have missed out on returns that are important for a long-term equity investor’s objectives. Deciding to sell or go defensive needs to be tactical and shouldn’t be based on gut feelings. Watching for these market signals can help you remain impartial and help you identify if a bear market is ahead so you can make decisions accordingly.