John Hussman: The Bollinger Band "Don't Enter" Signal

by: John Hussman

Excerpt from fund manager John Hussman's weekly essay on the U.S. market:

Jim Stack of Investech notes that the current bull market, at 4.2 years in duration, is unusually mature from a historical perspective. He notes, “Only 4 bull markets over the past 75 years had life spans which exceeded the current one.” Those included 1949 (which began at a price/peak earnings multiple of 6), 1974, 1982 (both which began at multiples of 7), and 1990 (which began at a multiple of 11 and ended in a hypervalued frenzy at nearly 34 times peak earnings). The current advance began at a multiple of 16, so even from the beginning we had less room for valuations to expand compared with those unusually long bulls... It makes little sense to “chase” the market here. Even any speculative positions investors contemplate would be best executed on a short-term market decline that clears the current overbought condition of the market.

Below, I've displayed a monthly chart of the S&P 500 going back to 1994. The chart also includes a set of “Bollinger Bands,” which form an envelope around the 20-month moving average. Though I don't follow “chart patterns,” I do find that various tools like Bollinger bands can help to improve our trade execution in the day-to-day management of the Funds. They also help in maintaining investment discipline.

Bolinger Bands

One of the immediate things to notice about Bollinger bands is that they don't provide very useful “buy” or “sell” points. Hitting the upper band, for example, is not a reliable signal that a security has peaked. Likewise, hitting the lower band provides no useful indication that a security has reached a trough. And though it seems from this chart like you could get some value from selling on a downside break of the moving average and buying an upside break, you tend to see a lot of “whipsaws” in practice. Also, the actual distance between the buy and sell points (based on the moving average signals) is not nearly as wide as the distance between the market's actual high and low.

So why bother with all of this? Well, there's a simple but important regularity that shouldn't be missed. Once the market has enjoyed a mature advance (not just an initial rally from a low, but an extended advance that has continued for some time, even if turns out to have even further to go), a move to the upper Bollinger band is almost invariably followed at a later date by a consolidation or a decline to a lower level. The same is generally true for individual securities, but the tendency is even stronger for markets as a whole.

Stated simply, it's almost never a good idea to buy the upper band in a mature market advance (which is where we are now). The market seldom “runs away” for long, and you generally have an equal or better entry opportunity later. That tendency is behind the relatively poor short-term market returns that emerge, on average, from the combination of overvalued, overbought, and overbullish market conditions. Again, the upper band is certainly not a reliable “sell signal” -- it's just that investors rarely ought to “chase” a mature advance when the market is already at (or through) the band.

Even this simple feature of market dynamics can help investors to avoid being swept away and buying into an overextended advance. My impression is that this sort of restraint is especially important here.

Read more John Hussman weekly essay excerpts on Seeking Alpha.