Predicting a Bear Market: 7 Signs and Why it's Tough to Do

Key Points

• A bear market is a decline of at least 20% in a specific index, sector or security.
• They're often difficult to predict since they occur rarely and tend to be short-lived.
• Many millions have been lost predicting bear markets that never materialize,

Are you trying to predict the next bear market? If so, you might want to consider the magnitude of the task first. Many millions have been lost predicting bear markets that never materialize, while significant drawdowns are triggered entirely out of the blue by events like COVID-19. 

Trying to predict the next downturn is difficult and often unrewarding, but that doesn't mean you should ignore all the warning signs. In this article, we'll examine how drawdowns materialize and review a few bear market indicators that occasionally give off smoke before a stock fire is visible.

Key Takeaway

A bear market is a decline of at least 20% in a specific index, sector or security. Bear markets are a natural part of the overall market cycle, but they're often difficult to predict since they occur rarely and tend to be short-lived.

What Are Bear Market Indicators?

Bull and bear market indicators come from different schools of thought depending on the type of analysis you want to perform. Looking at stocks from a short-term perspective, bear market technical indicators, like price resistance levels or momentum oscillators like the Relative Strength Index (RSI) showing overbought readings, could be helpful.

If you take a more extended look, macro signals like credit spreads, inflation, unemployment, and GDP could indicate a bear market. However, predictions based on macroeconomic data can be just as noisy as short-term price signals. Fundamental data like corporate earnings, revenue growth, and forward guidance can also provide clues about potential bear markets.  

Of course, a bear market indicator is just one factor to consider - never use a single technical indicator or fundamental data point without considering its context. If the market is trending higher, a bad earnings report from a big company like Apple Inc. (NASDAQ: AAPL) isn't necessarily a canary in the coal mine.

7 Bear Market Indicators to Use and Understand

How can you tell if something is a bull or bear market indicator? It's not so much that certain factors or oscillators are bearish or bullish, but the data or signal coming from the indicator.

RSI can show overbought and oversold levels, corporate earnings can miss or beat analysts' projections, and economic data can be better or worse than anticipated. The direction or trend matters; the more data you can use in your analysis, the greater the chance of producing an accurate prediction.

Here's a list of bear market indicators that have previously flashed warning signs before a downturn occurs. Remember that predicting bear markets is the toughest act in finance, and many of these indicators have given false signals in the past. Always combine different types of analysis if you're attempting to call a market top.

Yield Curve

The yield curve discussed as a bear market risk indicator is the ratio between the long-term and short-term Treasury bond interest rates. In typical market scenarios, the yield curve is upward moving — long-term debt yields more than short-term debt because the distant future is more challenging to predict than the near future. 

However, when the yield curve inverts, short-term Treasuries yield more than long-term ones, signaling that uncertainty is rampant and investors demand more compensation for taking on short-term debt. Yield curve inversion is often considered one of the best bear market indicators.

Credit Spreads

Another bear market indicator from the bond market is credit spreads, which measure the difference in yield between debt of identical maturity but different risk profiles. The spread between corporate bonds and U.S. Treasuries is the one to watch for macro analysis. When the spread of corporate and government debt widens, it could hint that private-sector lending is becoming strained.

Sector Rotation

Investors can also look to institutions and professional money managers for hints about market direction. Specific market sectors, like utilities and consumer staples, are less volatile than tech or retail, so asset managers often choose these companies when uncertainty is on the horizon. 

Valuations

Measuring company valuation against historical norms is a good way to predict if markets are getting overextended. Metrics like P/E ratios and profit margins are important, but more technical numbers like enterprise value/EBITDA and free cash flow should also be considered. Valuation metrics are how investors take the temperature of public companies, and when they get too high, the bear market risk increases.

Technical Indicators

Consider the following technical analysis tools when projecting future market trends:

• Moving averages: Simple or exponential moving averages use past prices to smooth out data and create a trendline. For example, a bearish signal occurs when a stock's 50-day moving average drops below its 200-day moving average.
• Relative Strength Index (RSI): RSI is a momentum oscillator that measures a trend by using the velocity of price changes. It can be bearish (over 70 means overbought) or bullish (under 30 means underbought).
• Moving Average Convergence Divergence (MACD): The MACD uses the 9-, 12- and 26-day exponential moving averages to project price trends. MACD can confirm a current trend or predict a trend reversal.

Fundamental Indicators

Here are some of the fundamental data points to keep an eye on:

• Economic data (GDP, unemployment rates): Bear markets don't always lead to recessions, but it's still prudent to monitor economic signals like GDP, wage growth, unemployment and inflation.
• Corporate earnings reports: A bear market is unlikely to materialize if companies report strong earnings beats. However, investors should examine the market's plumbing when earnings start missing analyst projections.
• Interest rates and monetary policy: Finally, the Federal Reserve deserves attention since its actions can move markets. Interest rates are a critical Fed tool, but so are programs like quantitative easing (QE) and quantitative tightening (QT). The effectiveness of Fed action is frequently debated, but these signals influence markets and investor behavior.

Sentiment Indicators

You might view yourself as a rational investor, but herd mentality is hard to ignore, and money makes people emotional. Buying low and selling high is easy in practice; it's another story when real capital is at risk. Here are some sentiment indicators that explain how market participants are feeling:

• Investor sentiment surveys: Data from optional surveys can be wonky, but indicators like the AAII Investor Sentiment Survey can still be useful for overall bullish or bearish expectations.
• Volatility Index (VIX): The VIX is usually called the fear index, which spikes along with market volatility and usually coincides with a stock market decline.
• Put/call ratio: Investors use options for various reasons, like speculation and hedging, so individual positions don't tell much. But when the total ratio of puts to calls rises, investors are taking more bearish positions. Likewise, when calls outnumber puts, it's considered a bullish indicator.

Steps to Take to Discover a Bear Market

Now that you have a grasp on the indicators of bear market analysis, here are the steps to follow: 

Step 1: Analyze key data.

Review the pertinent data before forming an opinion about the market's next move, especially if the future direction is down. Prognosticators are often mocked for predicting "10 of the last two bear markets," and doom-and-gloom market analysis can be good business for charlatans. If you're going to make a bear market call, you need to have a good reason and the data points to back it up.

Step 2: Prep your portfolio.

Has your portfolio taken on too much risk during the latest bull market? If you notice alarming data trends, ensure your portfolio is within your original risk tolerance parameters. If you're overweight certain stocks or sectors, adjust your allocation accordingly.

Step 3: Adjust your plan or stay the course.

If you think a bear market is coming, the real question is whether you should do anything. If you have a long time horizon and buy index funds, you might be better off staying the course since your portfolio has plenty of time to recover from a drawdown. 

Why It's Difficult to Predict a Bear Market

Bear markets are an unfortunate but necessary part of investing. When markets go too long without a drawdown, speculation runs rampant, and risk tolerance frequently takes a backseat to irrational exuberance. But despite being common, they're notoriously tricky to predict.

Even if you correctly predict a bear market, there's no navigation map. Volatility reigns during bear markets, and rallies during drawdowns frustrate buyers and sellers. Stocks usually refuse to drop in an orderly fashion. 

The S&P 500 has returned 10% or more in a single day six times in its history — four times during the height of the Great Depression (1929, 1931, 1932, 1933) and twice during the height of the Great Recession (2008). So, not only are bear markets short-lived and tough to spot, but violent bear market rallies can make short-sellers want to rip their hair out.

Many investors prefer dollar-cost averaging and predetermined asset allocation guidelines because they struggle to predict bear markets. Remember, market timing requires predicting the start and end of the bear market.

Investors Shouldn't Fear Bear Markets, but They Can Be Painful

Bear markets can materialize quickly, but the data often has warning signs beforehand. Investors can use technical, fundamental and economic indicators to make educated guesses on future market trends and remove (or apply) risk to their portfolios. Bear markets are standard parts of the market cycle and are inevitable if you invest long enough. Having a plan can help mitigate some of the pain, though.

FAQs 

Here are a few frequently asked questions about bear market leading indicators:

What is the best bear market indicator?

Many investors consider bond market signals like yield curves and credit spreads the most accurate bear market indicators. Still, a mix of technical, fundamental and economic data offers the best chance at accuracy.

What indicates that a bear market is over?

Bear markets are usually considered over when the market fully rebounds and makes a new all-time high. They vary in length but last about nine to 10 months on average.

What is the bear-bullish indicator?

The bear/bull ratio is a sentiment indicator used to survey market participants. It's not a forward-looking indicator but represents the market's overall mindset.