One Bank’s ‘Famous 5’ Bear Market Indicators Are Flashing Yellow

As noted earlier, there’s good news and bad news about the inevitable bear market (that would be the one people like Heisenberg have been predicting for years).

Let’s start with the bad news. The bad news is that there will be a bear market. Simple, right?

The good news is that you don’t actually have to call the top to avoid losses, because as Goldman reminds you, “selling after the first 3 months of the market peak would, on average, put an investor in the same position as one who sold equities 3 months before the peak.”

But let’s say, for argument’s sake, that you’re interested in predicting this ahead of time rather than simply waiting to confirm once stocks are down 6%. Because you know, if you’re leveraged or sitting on a bunch of retail WMDs like short VIX products, you won’t be solvent by the time you know for sure that things have actually turned and that the dip wasn’t bought by anyone but you.

Luckily, Goldman has identified the “Famous 5” indicators that, “in combination, tend to move in a particular way in the build-up to a bear market.”

Here they are:

1. Unemployment – rising unemployment tends to be a good indicator of recession: unemployment has risen prior to every post-war recession in the US. The combination of cycle low unemployment and high valuations does tend to be followed by negative returns.

2. Inflation – rising inflation has been an important contributor in past recessions and, by association, bear markets because rising inflation tends to tighten monetary policy.

3. The yield curve – related to the point about inflation, tighter monetary policy often leads to a flattening or even inverted yield curve. Since many, although by no means all, bear markets are preceded by periods of tightening monetary policy, we also find that flat yield curves, prior to inversion, are also followed by low returns or bear markets (Exhibit 29).

4. ISM at a high – typically very high levels of momentum indicators, such as the ISM and PMIs, tend to be followed by lower returns when the pace of growth starts to moderate. Exhibit 31 for the US and Exhibit 32 for Europe illustrate this. The highest returns are when the ISM is low but recovering, while the lowest are when it is low and deteriorating.

5.Valuation – high valuations are a feature of most bear market periods. Valuation is rarely the trigger for a market fall – often valuations can be high for a long period before a correction or bear market. But when other fundamental factors combine with valuation as a trigger, bear market risks are elevated.

So, what do you get when you roll all of those up? Well, you get Goldman’s “Bear Market Risk Indicator” and it is elevated (squarely in “yellow” territory):

So is there a silver lining here?

Of course there is. And predictably, it’s of the “bad news is good news” variety.

As long as inflation stays subdued, central banks will remain accommodative and the party can continue. Here’s Goldman one more time:

It is important to emphasise, however, that the lack of inflation and inflation expectations is one of the factors in the current environment that supports a much longer economic cycle and less volatility. In the absence of inflation pressures, monetary policy may remain much looser and reduce the risks of recession and, by association, bear markets.

In other words, CPI prints like what we got this morning don’t help.