Why U.S. Stocks are Still in a Bear Market and How to Determine When They are Not (+2K Views)

There is more than enough reason to believe that U.S. stocks are in a bear market regardless of what percentage drop has taken place. [Let’s take a look at stock momentum, various moving averages, volatility and certain technical indicators to see what they have to say in this regard.] Words: 700

So says Daryl Montgomery (http://nyinvestingmeetup.blogspot.com) in edited excerpts from an article* which Lorimer Wilson, editor of www.munKNEE.com (Your Key to Making Money!),has further edited ([ ]), abridged (…) and reformatted below for the sake of clarity and brevity to ensure a fast and easy read. The author’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement.

Montgomery goes on to say:

Momentum

The term bear market dates backs to at least the 18th century and was in common use on Wall Street in the 19th. All calculations were done by hand back then and changes in prices were all traders had to go on. Just as is the case today, much of [the] trading took place based on momentum. Traders assumed that if the market was going down, it would continue to do so and vice versa. At some point a 20% drop became the rule of thumb that a drop was serious and likely to continue. While 20% certainly indicates a  major fall in prices, the markets may or may not continue to fall after that level is reached.

50-day and 200-day Moving Averages

A much better approach, the concept of moving averages and the idea of using them as trading guidelines didn’t develop until the twentieth century. The 50-day and 200-day moving averages became the standard benchmarks for determining bullish and bearish patterns. This approach could only be widely implemented after computers became generally available. A bear pattern was established when the price fell below and remained below the 200-day moving average (the price would be trading at or below the 50-day as well). The bear would be confirmed when the 50-day moving average crossed the 200-day from above and moved below it. This is nowadays referred to with the dramatic term “death cross”.  This generally takes place before a market has lost 20% of its value.

The so called death cross took place for all the major U.S. indices in August and for many this confirmed that stocks were in a bear market. The 50-day, 200-day cross is prone to failure however. It tends to give too many false signals, as was the case in the summer of 2010 when all major U.S. indices also made this cross and then reversed shortly thereafter. Not only was there no bear market, but a major rally followed.

50-day (10-week) and 325-day (65-week) Moving Average

Instead of using the 50-day and 200-day moving averages as benchmarks, a more accurate bear market
reading can be obtained from using the 50-day and 325-day moving averages (or 10-week and 65-week moving averages).  While this will provide a bear market confirmation later, it will be more accurate when it does so. It takes a lot of selling energy to drive the 50-day moving average below the 325-day and if the market can’t accomplish this, a real bear market doesn’t exist.  Although this provides a later sell signal, it provides an earlier buy signal on the way back up.

The S&P 500 and the Russell 2000 made the 50-day, 325-day cross in mid-September, but had already made the 10-week, 65-week cross by the beginning of the month.  The Dow industrials and the Nasdaq made the daily cross at the end of September, but had already had a cross on the weekly charts by the middle of the month. Based on the weekly charts, the S&P was already in a bear market for a month before the 20% intraday drop took place on October 4th.

Volatility

Investors and traders need not rely on just moving averages to find out whether or not a bear or bull market exists. Volatility can provide an important additional clue. The daily price swings for stocks in the summer of 2010 were relatively minor compared to those in August 2011. Volatility is bearish for markets and its presence recently is just another confirmation of a serious and prolonged downturn.

Directional Movement Indicator

Modern technical analysis also provides a whole bag of tricks to help determine if a bear or bull market exists. The DMI (directional movement indicator) is the most directly applicable. Investors want to look for a  clear sell signal with a rising trend line on the DMI  on the weekly charts (the daily charts are too “noisy”). A sell signal was given in late July on the S&P 500, the Russell 2000 and the Dow Industrials. The trend line has been going up since then indicating a strengthening downtrend. A sell signal appeared in August for Nasdaq. It then failed, but a new sell signal was given in September.

Conclusion

Moving averages, volatility and technical indicators are all indicating that a bear market started in the U.S. somewhere between late July and mid-September 2011. This bear will not end until the 10-week moving averages cross back above their respective 65-week moving averages, volatility calms down, and DMI buy signals are given on the weekly charts. 

*http://nyinvestingmeetup.blogspot.com/2011/10/updating-definition-of-bear-market.html

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