I’ve heard many investors say the stock market rally may soon end and we may be on the verge of a bear market.
How concerned should you be? Is it time to trim equities after the S&P 500 Index has handed investors a 27 return this year, on its way to the best annual gain in 15 years?
The easiest and most accurate way to answer that question is simply by looking at the price action of the S&P 500. After all, the price of the market is determined by the aggregate opinion of every investor around the globe. And the fundamentals — the state of the economy, monetary policy, corporate earnings, etc. — are reflected in the charts.
But it’s not quite as easy as glancing at a weekly chart of the S&P 500. You have to know what to look for. In this uncertain environment, it’s instructive to compare investors’ confidence today versus their conviction the last time the major indexes were trading at comparable levels — in 2007.
The price of the S&P 500 acts like an economic survey where investors vote with their wallets. And on an intermediate-term basis, their votes indicate that they’re much more confident today than they were six years ago.
The blue lines in the above charts are the 50-day moving average. As you can see, the trend over the past year shows a much steadier upward progression than it did even in October 2007, at the peak of the earlier rally. This apples-to-apples comparison is a strong indicator that investors’ confidence in the market and the economy is much healthier now than it was in 2007.
Just as the 50-day moving average tells us about the intermediate-term outlook for the market, the 200-day moving average gives us a longer-term perspective. But both comparisons lead us to the same conclusion — the current bull market is much healthier than the previous one.
You can see that between April and December 2007 (points A and B on the top chart), investors were growing more indecisive about the economy. But it was not until the very end of the year that the rally definitively cracked, and the bear market of 2008-2009 began.
The trend in the 200-day moving average this year looks much different. And if we assume that the transition from bull market to bear market will follow a similar pattern this time, it means that we’re not yet approaching a significant and lasting plunge in stock prices.
The Four Tenets
I must point out that nothing is certain in investing. It is a strong likelihood, but by no means a given, that we’ll see months of sideways price action before a major correction.
This situation exemplifies the first of the four tenets of investment success I learned from Sir John Templeton, and have followed throughout my investing career:
- Think in probabilities
- Develop an” if, then” system
- Monitor the big picture
- Remain highly flexible
The charts above tell us the probability of an abrupt shift from today’s risk-tolerance profile to a bear market is relatively low. But a relatively low probability does not mean zero probability. So you must also follow rules 2 through 4: If the charts begin to shift as they did in 2007, you must be flexible enough to quickly reduce your exposure to stocks.