How to Recognize Signs of a Bear Market

A bear market is defined as a stock market that has fallen (-20 percent) or more from all-time highs (ATH) and lasting 60-days or more. The image of a bear clawing down illustrates the direction of stock prices coming down during this market phase. Bear markets often precede recessions due to the lag time it takes for GDP report releases. The 2001 Internet bubble and 2008 housing bubble/financial meltdown bear markets indicated signs of a bear market eight to 12-months before being dubbed a confirmed “bear market” and collapsing nearly (-50 percent) from the highs when the smoke cleared. Relying solely on economic data and conventional definitions can inadvertently leave investors ‘stuck’ with the crowd as the turmoil compounds. By focusing on the reaction and not the reason, investors can react before full transparency is materialized. We will quantify, pinpoint and illustrate these three distinct bear market triggers on the rifle charts for the benchmark S&P 500 (NYSEARCA: SPY). Using this knowledge, we can determine what can cause the current market to turn into a bear market, so readers can gain the foresight to prepare and plan accordingly.

Quantifying Exact Technical Triggers

Utilizing the historical rifle chart data, we can identify the exact triggers that led to the 2001 and 2008 bear markets. In reality, the official definition-based bear market confirmation (-20% from ATH lasting 60-days or more) came nearly a one year after the 1^st trigger and six-to-eight months after the 2^nd trigger formed. A bull market is identified with rising 5 and 15-period moving averages (MAs) which visualizes higher highs and higher lows. Prices rise higher when the stochastic oscillator rises. When the stochastic stalls or falls, the 5 and 15-period MAs act as price support levels (like bouncers at nightclub) that defend and deflect pullbacks long enough for the stochastic oscillator to cross back up to resume the uptrend. This underscores the “buy the dip” bullish market climate. As the stochastic pierces through the stochastic “overbought” 80-band level, short-sellers get squeezed and fund managers and investors come off the fence for fear of missing out (FOMO). FOMO causes buyers to chase prices with each new ATH.

1^st Trigger: All-Time Highs 

The first trigger forms when the ATH is made with the monthly stochastics above the 80-band overbought level. It was clearly formed in 2000, 2007 and so far in 2020. However, this is a “rearview” mirror trigger since every new ATH candle could qualify. This is why the 2^nd trigger is needed to confirm the 1^st trigger.

2^nd Trigger: Monthly Moving Average Breakdown

This second trigger is illustrated by the 5-period MA crossing down through the 15-period MA and the stochastic oscillator falling down through the 80-band. This illustrates the trend reversal from uptrend to downtrend. Remember how the 5 and 15-period MAs absorbed sellers on pullbacks to deflect them higher during the uptrend?  The same reaction occurs inversely in a downtrend. Buyers will try to push prices up but get absorbed and deflected back down off the 5 and 15-period MAs resulting in lower prices as each wave of buying gets rejected. Lower highs and lower lows are made on each bounce attempt. This trigger was clearly formed in 2000 and 2007. It has not formed yet in 2020, indicated by the “?” on the 2020 Current Market chart.

3^rd Trigger: Breaching the -20 Percent Threshold

This final trigger is the breach of the (-20 percent) from ATH price level accompanied by the 80-band stochastic crossover down. At this point the downtrend is in full force and panic ensues overshooting the trigger price on the way down. Usually this first test is also accompanied by a recovering bounce as bulls desperately attempt to push prices back up above the trigger level. In the 2001 bear market, the (-20 percent) trigger tested nine-months after reaching ATH and struggled to hold a bounce above there for three-months before finally plunging back under for the two-red monthly candles to officially confirm “bear market” status and the collapsed ensued. In the 2008 bear market, the (-20 percent) trigger tested simultaneously with the 2^nd trigger as the monthly downtrend formed. The 3^rd trigger tested and bounced four times before finally collapsing and confirming “bear market” a year after the 1^st ATH trigger formed. The current market (-20 percent) 3^rd trigger is $271.25.

Lessons from the Past

Based on the 2001 and 2008 bear markets, we can derive that the first tests of the (-20 percent) ATH threshold will likely be defended and deflected making it a solid bounce level. It took multiple attempts to breakdown before it actually occurred. However, the 5 and 15-period moving averages did not waiver as they updated lower, the bounces got smaller until the collapse through the 3^rd trigger. The lesson here is to utilize the initial spring like coils on the first test to consider rebalancing and adjusting long portfolios for a potential bear market. Traders can also anticipate reversion trades off the 3^rd trigger level which is currently at $271.25. This is where using smaller multiple time frame charts (IE: Daily, 60-minute, 15-minute) provide earlier signals within the framework of the monthly charts. Nimble traders can also utilize the fibs and sticky price levels ahead of the bargain levels to initiate trades. Make sure you do your preparation and plan your scalps ahead of time.

How Close Are We to a Bear Market?

Currently, the 2020 SPY monthly charts have triggered the ATHs (1^st trigger) as the monthly stochastic tests the 80-band stochastic and prices test the 15-period MA. The 2^nd trigger forms when the 5-period MA crosses down through the 15-period MA to form a downtrend. As prices fall to the (-20 percent) ATH threshold, investors and traders should brace for a reversion bounce back towards the 5-period MA and be aware that each rejection closes the gap setting up for a final 3^rd trigger breakdown. While this has historically taken up to 12-months to occur in past bear markets, the velocity of the current sell-off in 2020 has set a precedent. We will continue to monitor the SPY and provide potential trades and hedging strategies in future articles.