Sunday, 2 June 2013

Predicting Signs of An Approaching Bear Market

Stock analysts and traders have been for years try to predict the coming and ending of a bear market knowing that cracking the code would mean riches beyond one's imagination. Having the knowledge of when to exit and when to enter the stock market at the right moment is the ultimate goal of any analyst and trader. In fact over the years we have seen the rise and fall of so called "Investment Gurus" whom shot to fame over a correct prediction only to have the subsequent predictions failing. Is there really a way or method to correctly predict the stock market?  

As an investor, the concern is not about day to day or month to month trading of stocks. The primary objective of this post is to explore the signals dictating the movement of the US stock exchange, primarily the Dow Jones and the S&P 500. This "could provide" some form of indication if a bear market is approaching or not yet. I cannot guarantee that the accuracy of these signals, therefore readers should take these signals as a reference for stock investing.

Why not track the signals for Kuala Lumpur Stock Exchange? 
As a developing nation, our stock exchange index trend tend to follow the world's largest economy which is the United States. Therefore the movement of the Dow and the S&P tend to have a huge impact on our index. There will be some minor difference between the KLSE index and the Dow or S&P due to a internal issues of the country such as election, natural disaster, political unrest, etc. Otherwise, the general trend...I repeat the general trend of the KLSE index would mirror that of the Dow Jones.

1) US Purchasing Managers Index (PMI)
This index indicates the earliest stage of a manufacturing cycle. The PMI data is released on the first of every month and acts as an indicator of the country's economy.

Key Indicators: 
  • PMI > 50% - manufacturing is growing which is good for the economy.
  • PMI < 50% - manufacturing is not growing which is a bad sign for economy and the stock market
Where to see: 

2) The number of Stocks hitting new low in the New York Stock Exchange each day
This is a logical scenario whereby if more and more stocks are hitting new lows, then the possibility of a bear market approaching is likely. Another condition that has to be met is that while more stocks are hitting new lows, the index continue to create new highs

Key Indicators:
  • 40 or more stock hitting new low each day
  • While stocks are hitting new low, the index continue to reach new highs
Where to see:
3) Average Earning Per Share (EPS) of Stocks Becomes Too Expensive
A bear market tend to emerge whenever the stock market is overly optimistic. Overly positive sentiments tend to attract investors to buy, buy and buy, creating new highs on the index as well as raising the price of stocks. The stock market is considered overvalued when the average EPS for all stocks in S&P is selling about 21 times.

Key Indicators:
  • Average EPS of S&P selling more then 21 times
Where to see:

4) Price to Earning (PE) Ratio of S&P peaks at 25(x) earnings
Abnormally high PE ratios, combined with exuberant headlines, can be a signal that the market is overheated and equity exposure should be reduced. Abnormally low PE ratios, combined with pessimistic headlines, can be a signal that equity exposure should be increased.

Here's a historical look of abnormally high PE ratio before each bear market:

Over optimism has seen PE ratio going as high as 150(x) before a crash such as the one in 2008. Before the Dot-com bubble burst, PE ratio peaked at 40(x). Despite the fact that the PE ratio of S&P might not be an accurate reference to determine when the next bear is coming, investor should begin to take precaution whenever the PE of 25(x) is breached.

Key Indicators:
  • PE ratio above 25(x) earnings
Where to see:

There are probably many more indicators or signals that could help investors to prepare themselves for the next bear market. While none of us may be able to predict accurately the start of a bear market, indicators such as above act as an early warning for us. 

If you know of any other indicators not listed in this post, feel free share them by dropping a comment.

Cheers and Happy Investing

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  1. is this method can be used to detect bear market for malaysia only or also can be used for other market such as overall Asia Ex Japan, Emerging market and etc??

  2. Yes, I believe you can use it for other markets as long as you have the right reference values.

  3. I believe that this should not be used as an indicator of market sentiment by itself. With the macro economic news and government intervention thats been going on so often recently, it would probably be a good idea to also pay attention to events closer to home.

    Depending on what industry you're investing in, local knowledge (eg : businesses with a very strong local presence) and also product specific knowledge (eg : commodity prices for manufacturers) should carry more weight.

    Just my RM0.02 :)