While Zweig used many different indicators, he considered two of them most important : interest rates and debt growth. There isn’t a single indicator that’s correct 100% of time, usually they give confusing signals, so we have to be prepared what to pay attention to.
Goal of this article is to help the reader avoid the worst bear markets by either raising cash or selling short. I do not recommend shorting before a market (or individual stock) has topped. Always wait for a correction of at least 10%. I believe it’s impossible to forecast a top, and there is no need to do it. If you correctly assess a coming bear market, there is plenty of money to be made or losses to avoid many months after the actual top.
I have looked at the past 60 years and highlighted all corrections on S&P500 worse than 20%:
Interest rates and S&P500
Consumer debt and personal expenditures
After it reaches extremely low or negative numbers, it’s usually a good opportunity to buy stocks as the deleveraging effect has already happened in most part.
Rule: If markets are down at least 10% from peak and consumer debt growth starts declining, be careful.
Next chart shows the YoY growth of personal expenditures vs. corrections:
Rule: It can be said that when expenditure growth decelerates by at least 30% (let’s say from 10% to 7%), there is a high risk the correction will continue further.
Mortgage debt growth
Advance-Decline line is constructed at the end of each day. You simply take the number of advancing stocks, subtract the number of declining stocks and get a final figure. Over time this will develop into a line, which declines when more stocks are declining than advancing, and advances when the opposite happens. I have constructed my own line based on NYSE data.
How to protect yourself against severe bear markets
2. Shorting individual stocks – Best and hardest way to make money in bear markets. Do not hedge just for the sake of hedging. What will happen is that both your longs and shorts will go against you. Or as John Armitage once said: “If you need to hedge an individual position, perhaps you shouldn’t be in it.”
Short only into a downtrend and each stock you short has to be that of a overvalued company, in a competitive industry with accounting red flags and whose earnings or assets have a high chance of declining over next year or two. Shorting individual stocks is extremely hard and requires days of thorough research, after which you might wait years to realize any profit.
3. Selling long positions and going into cash – When markets have reached an elevated stage, P/E ratios are stretched and interest rates start going up, perhaps it’s a good idea to reduce some positions gradually and raise cash. You will sleep more comfortably and think with a clear head, which might help in determining the next step. However, do not get rid of all stocks in panic, as a bear market might not come and you will miss a lot of gains.
When interest rates are rising, indicators start flashing warning signs and markets make at least a 10% correction, the best way to protect a portfolio is to combine all three points. After a good year, buying puts for 1-2% of portfolio will not hurt much when you are wrong. Finding a good short candidate is tough but very rewarding. And lastly reducing positions in stocks which after thorough analysis seem to be overvalued, is a good way to take profits and raise cash to prepare for a bear market.
Where are we now?
Interest rates were very similar to current levels, and FED raised them 8 years after the crash. What followed was a quick recession, industrial production fell 20% and stock market lost half of it’s value in a few months. Realizing the mistake, they quickly reversed course and lowered rates, where they remained until 1941. 3-month treasury yield reached 0,02% during that time, which is the same value like now. Some prominent investors like Ray Dalio have raised concerns about FED’s plans to raise again, saying we might see 1937 again. After the 1937-41 bear, a huge bull market started that lasted more than 20 years.
For now, I will enjoy the ride but when rates start going up and markets down, I will quickly adjust to a new situation. Remember the goal is to avoid major losses during bear markets, not predict them precisely. Everyone wants to outperform the market, losing as little as possible during such periods is one way to do it.