Indicator Signals Bear Markets Ahead

Michael Carr
January 27, 2014

U.S. stocks became oversold after a sharp sell-off, while emerging markets entered bear market territory.

Stocks Oversold After Three-Day Sell-off
SPDR S&P 500 (NYSE: SPY) fell 2.13% on Friday and was down 2.59% for the week. Friday's sell-off left the major market averages deeply oversold. The chart below includes Bollinger BandsR along with prices.

The Bands are placed three standard deviations from the 20-day moving average instead of the standard setting of two standard deviations. Two standard deviations should contain 95.45% of the price action, while 99.73% of the price action should occur within the Bands when they are set at three standard deviations.

Friday's close, more than three standard deviations below the average, is expected to happen 0.27% of the time, or once every 370 trading days (about 18 months).

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Prices drop below the lower Bollinger Band a little more often than expected. This has happened 17 times since SPY began trading in 1993, or about once every 15 months, on average.

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Buying after prices fall this much would have been profitable in the short term. One week later, prices were up an average of 1.73%, and 67% of the trades would have been winners. One month later, SPY was up 80% of the time with an average gain of 2.88%.

Earnings also support the bullish argument for stocks. After a relatively rough start, the beat rate is back to normal. The beat rate is the percentage of companies that have reported results that exceeded analysts' expectations. On average, about two-thirds of companies beat earnings estimates every quarter. So far, 122 companies have reported fourth-quarter results, and 81 (66.4%) have beaten estimates.

Emerging Markets Enter Bear Market
Investors often use the magnitude of price moves to define bull and bear markets. Bear markets are defined as declines of 20% or more, and a new bull market begins when prices rise 20% above their bear market lows.

These definitions look backward, and investors can suffer large losses while waiting for a bear market to officially begin. They may also miss out on significant gains at the start of a new bull market.

The chart below takes a different approach. The indicator at the bottom of the chart shows where the close is relative to the closing prices of the past 52 weeks. When prices close at a new 52-week high, the indicator would be at 100. A new 52-week low would result in an indicator value of 0. When the value of the indicator is below 40, indicating that prices are in the lowest 40% of their 52-week range, the indicator is signaling a bear market.

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iShares MSCI Emerging Markets (NYSE: EEM) is now in a bear market.

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The next two charts show iShares China Large-Cap (NYSE: FXI) and iShares MSCI Brazil Capped (NYSE: EWZ) are also in bear markets. Other emerging markets show a similar pattern.

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Markets around the works are highly correlated with each other. Weakness in emerging markets could spread to the stock markets of developed economies. This happened in 1998 when a global financial crisis began in emerging markets and led to a sharp decline in U.S. stocks.

Emerging markets should be considered a warning sign that a pullback, or worse, is possible in the U.S. market.

This article originally appeared on
Market Outlook: Indicator Signals These Markets Have Entered a Bear Market

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