Here’s how to tell a bear market is coming

Trying to time the market can be dangerous, but there are certain signals that the professionals look for when trying to gauge future risk in stocks which could be helpful for regular investors to monitor.

Bank of America Securities curated a “bear market signposts” list for clients to help predict when stocks might be close to embarking on a bear market. The list of 19 signals ranges from fundamental to sentiment-related indicators and uses data tracking back more than 50 years.

Currently 63% of the bear market signposts have been triggered, up from 47% in January. Since 1968, when 80% of the indicators are triggered, a bear market occurred, meaning stocks fell 20% from their most recent highs.

“Stocks appear to be pricing in more good news than bad,” Bank of America equity and quant strategist Savita Subramanian said in a recent note to clients.

The signposts list was almost triggered in October of 2018 when it hit 79%. The S&P 500 went on to briefly dip into bear market territory on an intraday basis following that signal, and suffered its worst December since the Great Depression. The Fed raising rates, as they did in 2018, is a trigger on the bear market signal list, as bear markets have always been preceded by the Fed hiking rates by at least 75 basis points from the cycle trough.

1. Federal Reserve raising interest rates
2. Tightening credit conditions
3. Minimum returns in the last 12 months of a bull market have been 11%
4. Minimum returns in the last 24 months of a bull market have been 30%
5. Low quality stocks outperform high quality stocks (over six months)
6. Momentum stocks outperforming (over six to 12 months)
7. Growth stocks outperforming (over six to 12 months)
8. 5% pullback in stocks over the last year
9. Stocks with low price-to-earnings ratio underperform
10. Conference Board’s consumer confidence level has not hit 100 within 24 months
11. Conference Board’s percentage expecting stocks go higher
12. Lack of reward for earnings beats
13. Sell side indicator, a contrarian measure of sell side equity optimism
14. Bank of America Fund Manger Survey shows high levels of cash
15. Inverted yield curve
16. Change in long-term growth expectations
17. Rule of 20, trailing price-to-earnings ratio added to CPI is above 20
18. Volatility index spikes over 20 at some point within the last 3 months
19. Earnings estimate revisions rule

Currently, if investors buy a 3-month treasury bill, they will be getting a higher yield than if they buy a 10-year treasury note. This is not normal. Typically, the more long term the holding period of the government security is, the higher the returns. This is a bond market phenomena called the inverted yield curve, which is known to precede recessions and sits as one of Bank of America’s bear market sign posts.

Another indicator that is currently triggered is muted price reactions for earnings beats this season. Stocks are getting their thinnest rewards for beating Wall Street’s estimates on earnings since the first quarter of 2018 and the third lowest level since 2000, according to Bank of America.

“Historically, small rewards preceded negative S&P 500 returns 60% of the time over subsequent quarters,” Subramanian added.

Stocks with low price-to-earnings ratios are also currently underperforming, flashing a bear market warning sign. Stocks with low PE ratios are generally considered undervalued and can be a good buying opportunity. When investors don’t buy into these cheap stocks it normally means they are crowding in high growth names. This means that the most expensive stocks are narrowly driving market returns.

Another flashing signal is tightening credit conditions, which occurs when it becomes harder to borrow money from the bank. In times of uncertainty or an economic slowdown, banks will tighten their lending taps to hedge for risk. Each of the last three bear markets started when a positive percentage of banks tightened lending standards. A recent Fed survey showed banks expected credit standards to tighten this year.

One indicator that remains at bay is Bank of America’s Fund Manager Survey recommended cash levels staying above 3.5%. Typically, when fund managers are not recommending positions in cash to clients, it’s bullish; however, Bank of America said it can be a contrarian measure of buy-side optimism. Therefore, since the current recommended cash position is above 4%, the signpost is not triggered.

A change in long-term growth expectations is another indicator that is currently not triggered. While stocks are off their recent highs due to worries about the Chinese coronavirus and companies like Apple and Coca-Cola downgraded their earnings expectations due to supply chain disruption, the consensus seems to be that the financial fallout of the virus will be short lived. Near-term pain is being acknowledged; however, Wall Street firms are optimistic growth will recover in the second half of 2020.

Another recent bullish signal is that consumer confidence in the U.S. grew more than expected in January as the outlook around the labor market improved. The Conference Board’s consumer confidence index rose to 131.6 this month from 126.5 in December. Economists polled by Dow Jones expected consumer confidence to rise to 128. Any reading below 100 signals a bear market could be coming.

When the Cboe Volatility Index, a commonly watched fear gauge, spikes above 20, it triggers another bear market warning sign. Despite coronavirus and U.S. presidential election uncertainty, the VIX sits below 17, which remains bullish for equities.

To be sure, while this method developed by the bank has a good track record, it’s always possible that different factors accompany the next bear market. And most professionals advise against trying to time the market based on technical factors such as these.

Still, it could be a helpful exercise for regular investors to go through this list in order to gauge how much risk they should be taking with their investments.

— with reporting from CNBC’s Michael Bloom.

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