Earlier this week, we brought you Goldman’s “Famous 5” bear market indicators which, in combination, “tend to move in a particular way in the build-up to a bear market.”
Those 5 indicators are listed below along with short excerpts from the bank’s accompanying color:
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.
When you roll all of those up in an effort to get a read on how high the risk is that a bear market is just around the corner, you find out that at 67%, the risk of a bear market is high.
So the enterprising among you might ask yourself what the percentages around that indicator look like. Or, in other words, given a level “X” on the bear market indicator, what are the chances of being in a bear market in the next “X” months. Well, Goldman has you covered. Here’s the table:
Alternatively, what does history say about the frequency of losing more than 20% for a given reading on the indicator? Here’s the breakdown on that:
When Goldman looks at this, they use the bear market indicator ex-valuations (so, the gray line in Exhibit 38 above as opposed to the navy blue line). But let’s pretend valuations matter for our purposes (there’s a joke in there somewhere). With the bear market risk indicator sitting at 67%, history suggests the chances of losing more than 20% over the next 24 months are 33%.
So the question is: do you like those odds?