How Not to Identify a Bear

Accurately identifying a bear market can help investors avoid some tough equity market losses. And while avoiding a bear isn’t necessarily required to achieve your long-term investment goals, it can certainly help. Unfortunately, doing so is very difficult and investors often struggle to recognize if a downturn is a bear—by definition a fundamentally driven equity market decline of 20% or more over a longer period of time, or a correction—a sharp sentiment driven fall of 10% or more. For investors looking to identify a bear market, understanding what can or can’t signify a bear is essential.

Using a recession to identify a bear

One common misconception of bear markets is that they happen at the same time as the economy experiences a recession. While it is true that bear markets usually pair with recessions, they generally don’t start simultaneously. Equities are a leading economic indicator. Bear markets usually begin months before recessions do. See Exhibit 1, which compares US bear market and recession start dates since 1926.

Exhibit 1: Bear Markets Usually Begin Well Before Recessions Do

Source: FactSet and National Bureau of Economic Research, as of 13/02/2018. S&P 500 Index daily price level, 1926 – 2016. Presented in terms of US dollars. Currency fluctuations between the US dollar and Canadian dollar may result in higher or lower investment returns.

Equities also tend to peak long before employment does. Exhibit 2 compares US bear markets with US nonfarm payrolls (measurement of US workers in the economy that excludes farm employees, private household employees and some non-profit employees).

Exhibit 2: US Nonfarm Payrolls and Bear Markets

Source: FactSet, as of 13/02/2018. Monthly US nonfarm payrolls and S&P 500 Index daily price level, January 1939 – January 2018. Presented in terms of US dollars. Currency fluctuations between the US dollar and Canadian dollar may result in higher or lower investment returns.

If investors wait for confirmation of a recession before declaring a bear market, you could very well be too late to make it worth their while. While nailing the market’s peak isn’t necessary, getting out of equities is wise only if there is still a high likelihood of significant downside to come. Keep in mind, recessions are visible only in hindsight. Because economic indicators are variable from month to month and quarter to quarter, a recession usually isn’t apparent until several months in, when it becomes clear market conditions are broadly deteriorating and it isn’t a blip. At that point, you could be six, eight or more months into a bear market. Some bears last long enough that this is still an attractive exit point—2000 comes to mind—but some are nearly over by the time a recession announces itself.

The key is forward-looking indicators

If avoiding part of a bear market is your aim, you must use forward-looking economic indicators to gauge whether a recession is likely to develop—not backward-looking measures of past output and employment. The Leading Economic Index (LEI) is a helpful financial tool, as it aggregates 10 mostly forward-looking economic variables. It doesn’t predict equities, as equities are one of its 10 components, but it can help you gauge whether market volatility is noise or a signal of more serious economic trouble to come. The yield spread—which measures long term interest rates against short-term interest rates—and inflation-adjusted monetary supply, which are also in LEI, are other good gauges. When yield spread inverts (short interest rates exceed long interest rates) and stays that way for a chunk of time, it usually means credit will tighten within the next several months—and tighter credit usually causes business activity to fall.

Other timely signs of trouble can be a broad drop in lending by financial institutions, a sustained drop in manufacturing orders or Purchasing Managers’ Indexes (PMI) factors—which are economic indicators based on surveys of executives at manufacturing and service sector companies. These generally aren’t as forward-looking as market-based indicators, but they can precede declines in actual output.

Then again, this is all more art than science. There is such a thing as a recession-less bear and such a thing as a bear-less recession. After all, economics are only one market driver—political conditions (e.g., legislative and regulatory risk) and investor sentiment have heavy influence, too. This is why investors should keep in mind that bull markets usually end in our opinion in one of two ways: the wall or the wallop. Either sentiment climbs all the way up the wall of worry, where euphoric investors have too-high expectations for future corporate profits, or something huge, ugly and broadly unseen wallops the bull market before sentiment runs its natural course.

This isn’t to say you should ignore economic data. They can be very useful in identifying market trends, confirming your earlier outlook or adding to your understanding of a key input for equities. But when markets get rocky, solid Gross Domestic Product (GDP, a measure of economic output) and employment numbers should be no comfort that a bear isn’t forming. Instead look at whether the yield curve slope is positive, whether LEI is high-and-rising, how strong loan growth is, and whether there are strong new orders/new business readings and relatively low legislative risk. We believe these forward-looking data points help determine whether market volatility is sentiment driven, or volatility is due to a bear market forming.