How to tell if we’re heading for a bear vs bull market and what to do when stocks crash
The stock market crash last December shocked investors out of a ten-year slumber. The feeling, as it always is during a bull market, is that stock prices can’t do anything but go up.
That sentiment is quickly broken in a crash and portfolios ruined.
Stocks have rebounded and the feeling of optimism is back. Was the selloff just a quick blip in an otherwise solid year of more gains or are we heading for a third stock market crash in 20 years?
My crystal ball is in the shop so let’s look at what happens in a bear market and some signals you can use to avoid a stock market crash.
What is a Bear Market vs Bull Market?
Technically, a bear market is any time stock prices fall 20% or more from their most recent peak. This is why you might hear someone say that individual investments, like tech stocks, have already entered a bear market even if the broader market is still in a bull market.
Bull markets aren’t so well-defined. These are only known by sustained higher prices from the low of the last bear market. So the current bull market is measured from the March low in 2009.
Since we’re talking bull vs bear and stock market prices, you might also hear the term correction thrown around. A stock market correction is when prices fall 10% from the most recent peak.
Maybe a better definition of bear vs bull market is just the feeling and overall investor sentiment. Panic and despair take over in a bear market crash while enthusiasm and optimism are pervasive throughout a bull market.
Data compiled by MacKenzie in the graphic shows some interesting facts about bear and bull markets. The stock market has increased for an average 52 months during a bull market, rising 160% from the bear market low. By comparison, bear markets have lasted an average of 14 months from the bull peak in prices to the low.
What Causes Bear Markets?
We’ll look at the biggest warning signs of a bear market next but what actually causes the bear to roar in the first place.
Generally a stock market crash and bear market is associated with a recession. This makes intuitive sense. Stocks are an ownership of future corporate earnings so a lower earnings outlook due to a recession means stock prices need to come down.
Of the 14 bear markets since WWII, only five have happened while the economy was still growing while nine have occurred because of a recession. It should be noted that those five occurring outside a recession happened while economic growth was slowing though still positive.
So even if we’re not expecting a recession, most economists are expecting economic growth to slow down and a bear market isn’t out of the question.
How Do You Know When a Stock Market Crash is Coming?
So how do you know when a stock market crash is coming? Are there reliable signals to a recession that can tip you off for when to take your stock market money and run?
It turns out there are warning signs for a recession and the falling stock prices it brings. These are mostly economic data that point to weaker growth or business activity.
The problem is that no single warning sign has proven 100% accurate to forecasting either a recession or a stock market crash. Used together with a little common sense though and you can get a good idea of when the stock market is flashing a yellow caution sign.
In fact, most of the Wall Street brokerage houses have their own recession indicator program that combines the signals below into a percentage guess at the likelihood of trouble.
The first stock market warning signal, and by far the most popular, is the rate difference between the two-year and the ten-year U.S. Treasury Bond. The interest rate offered on the ten-year is usually much higher than the short-term bond. It makes sense because investors in the longer-term bond investment generally want a higher return for being locked into such a long period.
The yield curve is a graphic of all the rates on the Treasury bonds so you get a ‘curve’ that usually slopes upward on longer-dated bonds. When the interest rate on the two-year is more than the long-term bond however, the yield curve is said to be inverted because it falls from higher to lower.
The reason why this signals a recession is because the rates on Treasury bonds is largely a function of what investors think they’ll be at in the future. If the market expects weak economic growth and inflation in the future then they won’t demand as high a rate on bonds that cover that time period. Rates on short-term bonds are more influenced by the Federal Reserve so you can get rapidly rising short-term rates even as the economy is slowing.
You can see from the chart that the rate difference has been a very reliable indicator for recession. Each time the yield curve has inverted, each time the spread goes negative in the chart, a recession wasn’t far behind. You can also see that we’re very close to that point in 2019, with the narrowest Treasury spread we’ve seen since before the 2009 recession.
The VIX volatility indicator is another stock market signal though it’s a little misleading because it measures what it supposedly predicts.
The VIX is an index created by the Chicago Board Options Exchange to measure investor sentiment as a predictor of the next month. The index is often called the ‘fear gauge’ because it rises as investors get nervous and stock prices fall.
Investors watch the VIX as a warning that anxiety over stocks is getting high. When this happens, it might not take much for investors to stampede to the exits on any bad news.
The problem is that it’s a bit of circular logic. Cracks start appearing in the economy and investors get nervous. The VIX rises on the drop in stock prices and investors get more nervous. This causes the VIX to keep rising and the market begins to panic.
The VIX has led recessions but it’s not altogether reliable as a predictor so take this one with a grain of salt.
Of all the stock market crash signals, the weekly jobless claims is my favorite and the one used most often by professional analysts. The data is reported each Thursday and has been an extremely reliable warning sign for recessions.
The monthly unemployment number gets a lot more public attention but it’s the initial claims, those filings for unemployment, that have been the better indicator. I use the four-week average of jobless claims to smooth out week-to-week changes that might not necessarily indicate real weakness.
Jobless claims are a great recession predictor because layoffs are so important to the economic picture. As more people are laid off, a cycle takes hold that can destroy the business cycle. People have less money to spend which means companies start dialing back their plans and lay off more people.
You can see from the graph that it’s not the level of jobless claims that signals a recession but when claims start to turn higher after hitting a low. We’re at the lowest unemployment claims we’ve seen in decades but this number will change, and when it does…watch out!
Inflation is a less of a recession indicator but is no less important. Prices can jump around from year to year and may not signal a stock market crash but there are two reasons why you need to be watching this one in 2019.
First is because nobody is expecting inflation to increase much. Inflation has been almost non-existent over the last decade versus history and people have gotten used to that. If prices do start rising quickly, businesses will have a hard time passing costs on to consumers. That’s going to mean weaker corporate earnings and the stock market will have to adjust to that new reality.
More importantly though is that faster inflation growth will force the Federal Reserve to raise rates. Cheap rates and stimulative monetary policy from the central bank has driven the stock market to an all-time high. The 2018 stock market selloff was because of the Fed’s policy of raising rates while the rebound in stocks can be directly attributed to softening language by the central bank on rates.
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What Can You Do to Not Lose Money in Stocks?
We’ll look at all these signals and whether we’re heading for a stock market crash in 2019 in the next section. First though, what should you do if you expect a bear market this year?
First is Don’t Panic!!
I know it’s easier to tell investors not to panic during a bear market than to actually follow the advice. The reason stocks crash though is precisely because everyone is panicking. A panic feeds on itself and the only investors that make money are the ones that keep their cool and wait for calmer times.
If you think a bear market is coming, ask yourself three questions to decide what you should do.
What is your time horizon? When will you need the money from your investments?
If the answer is more than ten years then sit back and don’t worry about a bear market. Even if stocks plunge, you’ve got plenty of time to watch them rebound. The average time it takes for the stock market to recover from a crash has been 22 months since WWII. That means you’ll likely see a few bear markets before you’re done investing but lots more market growth as well.
Have you rebalanced your portfolio lately?
Rebalancing is shifting your investments back to your original targets or the amount you want in stocks, bonds and real estate. Staying on these percentages gives you the perfect level of risk and return for your needs. This is going to depend on your age and risk tolerance but generally younger investors want between 55% to 70% in stocks, 15% to 20% in real estate and a similar percentage in bonds.
If you haven’t rebalanced your investments in a couple of years, they could be far from that target. Stocks and your real estate investments will grow rapidly in a bull market, leaving the amount you have in bonds far behind. Pretty soon, you might only have 5% of your total portfolio in bonds and too much in stocks.
If you think a bear market might hit your stocks and you haven’t rebalanced in a while, you might consider shifting some of your money from those over-weight assets back into others. It’s a great way to make sure you’re on the right track and protect your money.
Are you diversified into multiple assets and within each asset class?
This question relates to the prior but is just as important on it’s own. Do you have different asset classes; i.e. stocks, bonds and real estate, in your portfolio or is it all stocks? Within your stock holdings, are you invested entirely in growth sectors like technology or do you have a good mix of different sectors?
You shouldn’t wait for bear market signals to diversify your portfolio. A healthy portfolio should have a mix of investments within assets as well as at least the major asset classes of stocks, bonds and real estate.
Want to see what I do when the market panics? Watch this video for five safe investments in a stock crash!
Is a Stock Market Crash Coming in 2019?
After asking those three questions about your portfolio, the question of whether a stock market crash is coming in 2019 might not be as important.
The equity analyst in me can’t resist though so let’s look at the bear market warning signs.
Nearly all of the economic signals are pointing to an overheated economy, one that could turn lower. Most economic organizations including the Federal Reserve, the IMF and OECD are forecasting a slowing U.S. economy for 2019 though none are talking of a recession.
The fact is that a $20-trillion economy doesn’t turn on a dime. The economy will slow before it turns into a full-blown recession so even if one is in the picture, we probably have time as investors to keep watching the numbers.
We’re certainly on the wrong side of the economic cycle, surfing down the downward-sloping wave of the business cycle. Just looking at stock valuations, history doesn’t paint a terribly pleasant picture. At today’s price-to-earnings valuation of 20-times for the S&P 500, history suggests an annualized return of just 5% for stocks over the next decade.
That return isn’t great and is well under what many people are using to plan their retirement. Instead of settling for the sub-par growth, it might be time to do that rebalancing into bonds and real estate to protect a little more of your money from a stock market crash.
The question of whether we’re heading for a bear vs bull market isn’t one you can answer with a simple yes-no solution. It’s a question that can only be answered by understanding the warning signs of a stock market crash and your own needs as an investor.