Are We in a Full-Blown Bear Market? We Search Historical Patterns for Clues

January 4–8, 2016 has gone down as the worst opening week of all time, and the following week was just as bad! So it must be the start of the predicted bear market, right? Well, since we try very hard not to give the impression that we can predict the future, we can’t really say one way or the other. All we can do is weigh the various factors and calculate a probability of future events.

The future, like the quantum realm, is not accessible to our senses. The quantum world does not operate like the three dimensional (plus one time-dimension) universe that we have evolved to live in. The sub-microscopic quantum world is accessible to us Humans only as indefinite probabilities, and the future, as well, is only accessible to us as probabilities. A fact which is hard to reconcile with our sensory macroscopic experience.

These probabilities, that can give us an idea about possible futures, are calculated from historical information. Let’s look at some historical patterns that might provide us with future probable outcomes.

Let’s start with the fact that a bear market has been expected by an increasing number of market followers ever since the China-triggered drop last August. This fact alone pushes the probability AGAINST a sustained market turn. There is too much fear in the air to make a bear market likely.

You can see in the graphs below, that the Bulls are at 17.90 (below 35, is bullish), and the Bears are at -45.50 (below -50, is bullish) which means there are 2.5 times as many Bears as Bulls (Bull/Bear=0.39). The fact that the Bears are still above -50 means that it is likely that the recent slide is not quite finished.

These low bullish levels (17.90) are close to the lowest levels we have had in the last five years. Bear market breakdowns don’t often happen when bullish sentiment is this low.

The next chart compares the long-term (20-year) relationship of the S&P 500 to the percentage of bullish investors (AAII BULLS).

The blue lines indicate the eight times when bullish sentiment was below 22%. Of these, the S&P 500 rose seven times following these lows (the eighth time is the most recent low which has not formed a pattern yet). Even in 2008, the S&P rose for the three months following the January to February low bullish reading. When the bullish reading hit 53% in July, 2008, the S&P collapsed. A low bullish reading of 17.90% is predicting at least a short-term rally, not a bear market.

Work at the New England complex Systems Institute suggests that the panics that lead to crashes come from increased mimicry in the market. That is when more and more participants start doing the same thing in the market, making it easier for panic to take hold. That is why we watch for extremes in sentiment in either direction; if the crowd moves too far one way, a panicked reversal of direction becomes increasing likely.

The fact that the S&P 500 was in a trading range for most of 2015, indicates that there is no consensus among participants. We do not see the herd running like blind bulls in the same direction, therefore we don’t see a high probability of a bear market reversal at this point in time.

The Rydex Bull Fund Index measures the flow of investor money into bullish funds. The chart below shows how low Rydex readings correspond with local minima on the S&P 500. When investors are fearful of owning stocks, the chances are good that stocks will rise. At the moment, investment in the Rydex Bull Funds is at a relatively low level, which indicates a rally in the near future.

A long-term pattern that we have outlined on the 20-year chart below, is a convergence (green) and divergence (red) between the Rydex and the S&P. Both the 2000, and 2008 bear markets were preceded by a divergence of the two indexes; the Rydex fell while the S&P rose. At the moment, there is no divergence. The implication is that we are experiencing a market correction, albeit a serious one, but it is unlikely to be the start of a bear market.

Another factor that is pointed to by many market pundits is the present valuation of stocks. This is tricky because there are different ways of measuring this. One way is through the Shiller Price/Earnings ratio which as we can see below, is not at an extreme. This does not give us a probability either way.

Shiller PE for the SP 500

A different way to look at the value of equities is with the Price to Book Value for the SP 500. Here again, the price of stocks being two and a half times their book value is not excessive and so we assign it a neutral probability.

S&P 500 Price to Book Value

So, as we look for factors that could provide us with evidence of a probable market breakdown in the near future, we come up empty handed. We find that the probability of this being the start of a bear market, to be very low. We may not have reached the bottom of the correction, but it seems to be close at hand.

Having said of all that, we have point out that the last decade has seen the proliferation of ETFs and algorithmic (high-frequency) trading to a level that dominates the major markets (~70%). Markets have always been driven by human brains and therefore human psychology, especially as it applies to crowds.

But it may be that psychological indicators are not as relevant as they once were. Since only 30% of trading is done by living brains, if a majority of the algorithms start to mimic each other for purely mathematical/statistical reasons, then both the mimicking and reversal in direction could happen in microseconds. Witness the “flash crashes”. We aren’t saying that “it’s different this time”, just that the possibility is there. Algorithmic trading is new so there is very little history for us to learn from.

In conclusion, even though the market is likely to drop a little further, we don’t see a full-blown bear market as a probable event at this time.

ANG Traders

Forty years of private equity trading, and still learning.

Forty years of private equity trading, and still learning.