Predictors of Bear MarketsThere is a lot of great data on the chart about various bear market predictors but below are a few of my favorites that are easier to understand and available to individual investors. Before you even get started, you can see how a bear market will affect you in my post if you’re not sure or Are Stocks Safe for Retirement?
Invested Yield CurveIn the checklist, an invested yield curve is indicated by a 2 Year Treasury note yielding more than a 10 Year Treasury bond. Normally, a longer term investment has a higher yield than a shorter term investment. An inverted yield curve is a reliable predictor of a recession. As you have read here, bear markets happen when (usually after) the economy slows since company earnings slow. In case you missed it, catch up by reading “How to Prepare for Bear Markets.” Note that whether or not the yield curve is inverted can change whenever the Fed changes interest rates. (See what Ray Dalio, Warren Buffett and major investing experts are doing in my post What Will Stocks Do over the Next 10 Years?)
Trailing PE RatioPE stands for price earnings ratio. This relates to stock market valuations, another popular topic here at Retire Certain. You get the PE ratio by dividing the price of a stock by the earnings of a stock, but a single stock’s PE ratio won’t tell us much about the stock market as a whole. So, we use the PE ratio for a stock index instead since an index represents a market vs a single stock. And the Trailing refers to the past 12 months earnings. This is as opposed to future earnings, which really can only be estimated. The chart calls this “Fwd PE”, which stands for Forward PE ratio. Here’s the logic behind the PE ratio and using it as a predictor of bear markets: Investors are willing to pay up to a certain amount for earnings before they decide they are paying too much. And once investors decide they need to pay too much for stocks, they stop buying them. They may even decide to start selling stocks because valuations have gotten so high. You can see the simple logic here. Again, when we invest with logic, historical data and math we are less likely to invest with emotions. (Been there and done that.) Read my post with related information: Best Assets to Build Wealth.
CAPEThe CAPE is a new and improved PE ratio. It stands for Cyclically Adjusted Price to Earnings ratio. The CAPE is obtained by dividing the average earnings in the prior 10 years adjusted for inflation. This tells us how much of a company’s (or the stock market’s) earnings were from inflation vs true earnings. To put this in perspective, the CAPE has had record high levels only 3 times in the past:
- In 1929
- In late 1990’s before the Dotcom bear market
- In 2007 before the bear market of 2007-2009
Balance Sheets and Credit MarketsNet Debt/EBITDA is another red warning on this chart. There are also 2 gold warnings under this category. EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization. So, by dividing the Debt by EBITDA, you can get a leverage measurement. High leverage is risky. My post Reducing Risk in Stocks has more about stock market risk.
Reliability of Bear Market PredictorsWhile it’s comforting to see that only three of the bear market predictors are red, there are several things worth mentioning.
History from More Bear MarketsI notice that the data is only shown for the bear markets that began in 2000 and 2007. What would this data reveal if other bear markets were considered? My post Stocks That Went Up in 2008 has information about stocks, gold and ETF’s that went up in the 2008 bear market.
Conflicting DataAt any given time, we can find data to support continuing bull markets as well as looming bear markets. Data can be presented in different ways to reflect the intended and desired message of the company that produces it. While this data is clearly solid, we could find conflicting data if we tried.
Stock Market RiskIt’s important to remember that:
- You don’t have a realized loss unless you sell stocks at a loss.
- Bear markets are a fact of life for stock market investors. They happen.
- You have plenty of wealth to sustain your standard of living for life without having to sell stocks.
- You have several income streams that will pay your bills without having to sell stocks during bear markets.
- You are a young investor who has chosen a diversified, long term buy and hold investing strategy.
- You don’t object to your net worth declining for a few years.
- You only own stocks at a very low cost relative to their current value.
Summary for Predictors of Bear MarketsNo one can ever guess the exact time the next bear market will raise its gnarly head and roar. But by being aware of the predictors of bear markets, you can invest accordingly.
The information on this website is for education only and is not to be construed as personal financial advice.