How To Recognize A Bear Market Bottom

Summary

• Specific statistical signals accompany bear markets.
• These signals occur in a sequence.
• Each one of these signals has been met in the March/April bear market, followed by one of the strongest rebound-rallies ever.

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In his classic book, The Reminiscences of a Stock Operator, Jesse Livermore opined that his greatest discovery was understanding the importance of market direction. He had experienced a few surprise losses after he thought he had done everything right, and realized he could be perfectly right on his stocks, but wrong on the market's direction, and lose all his profits.

So he turned to index investing - what he called in his day "the list" - and to the "lines of least resistance" in the overall market. He vowed to "never fight the [ticker] tape" again. And after a lifetime of trading, he seemed to develop an inner sense for the ebb and flow of the market.

We can see this principle at work in the stock market of our day. The Dow has only 30 stocks, but my little hotel stock still dances to its tune. The Dow's ups and downs seem to orchestrate its ups and downs too. Why does something so apparently unrelated have such an outsize influence on my small-cap? It's because the stock indexes are the kings, the rulers of the market, and we ignore them at our peril.

If you objectively look at the content expressed on CNBC - and the articles here on Seeking Alpha - you will see that market direction is the primary concern of the authors, presenters, and bloggers. And in my 30 years of observing the markets, I cannot remember a time of such anxiousness, doomsdaying, anger, pessimism, and yes, glimmers of hope too.

As investors, we are psychologically attuned to the search and need for safety. Any threat to that safety is viewed warily. Think of our news outlets as economic gossip. Listen to 100 nice things about the economy and we yawn. Say one bad thing about what could happen to it (especially to one of our stocks), and we are all ears.

We need, we crave, a mathematical strategy that will allow us to "know" about the market and will not interfere with our capacity to trade it effectively. Mark Twain put it like this: "It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so."

Take for instance this comparison. A martini-glass is filled with water at the halfway mark (by the way, the market has just completed a 50% retracement off the March lows). Is the glass half empty, or half full? Ninety percent of the recent articles I read is an attempt to answer this uncertainty, and marshal "facts" to support a hypothesis one way or another. It's a competing battle of bullish and bearish authors passionately searching for certainty through belief and evidence.

If it's half empty, then this is surely the time to "Sell in May and go Away". But if it's half full, then the angry mob on the sidelines - who has watched this improbable rally leave the station without them - will be left behind again too. As one bullish author put it, "Your 401k doesn't care about the authenticity (or not) of this rally."

What are the lines of least resistance here? Where does "don't fight the Fed" (and Donald Trump too) meet 30 million unemployed workers and a myriad of small businesses in ruin?

Let's take a look at the developmental sequence of a bear market, from beginning to end.

1) Inversion of the Yield Curve

An inversion of the yield curve has predicted seven of the last seven recessions with no false positives (7/7). See 10-Year Treasury Constant Maturity Minus 3-Month Treasury Constant Maturity (T10Y3M). The most recent inversion was May 20, 2019. The previous one was July 26, 2006.

If an inversion of the yield curve has occurred within the previous six to 16 months, an investor should be on high alert for any future crossover of the SPX 500 below its 200-day simple moving average [SMA]. Such a movement could herald the beginning of a bear market.

2) The SPX 500's 200-day moving average

All stock market charting systems have a method to chart this moving average with a few mouse clicks.

To grasp the logic of the SPX 500's 200-day moving average, the S&P 500 is considered the core of American industry and economy. A global battalion of investors and analysts trade billions of shares each day in the S&P's 500 publicly traded companies.

Over the course of those 200 days (approximately 10 months of trading), the direction of the S&P 500 - relative to its long-term average - will be clarified by these traders. In a sense, we rely on their intelligence to ascertain the SPX's relative value through time.

In a bull market, the SPX 500 will move consistently above this moving average. A long-term investor holds the course or buys the dips. During the last 28 years, 24 of those years were spent with the index above this moving average, sometimes in stretches lasting for years.

In a bear market, the index will break below the 200-day line dramatically and continue lower in the weeks ahead. In the 2000, 2008, and 2020 bear markets, a powerful waterfall-like decline began in a matter of days. Relentless in its follow-through, computers pushed massive sell orders ("Get me out!") through to the indexes, compounding the downside momentum with a ferocity and a swiftness that was breath-taking and infuriating.

The safest strategy, therefore, is to get out before this happens. And that is the purpose of the 200-day moving average: to warn you ahead of time. Avoiding the catastrophic losses of a bear market will provide you emotional distance from the fray that ensues, plus raise cash for the next time a safe buying opportunity arises. As stated above, 24 of the last 28 years (86%) were safe times to invest. Only 14% were not.

3) Market bottoms - panic selling

The essence of a market bottom is panic selling and it can be measured. Panic selling ensues when investors "puke up" their stocks to relieve themselves of the pressure of holding on while a tsunami of selling washes over them. These selling stampedes usually last between 17 and 21 days and are interspersed with only a few hours or sessions of market rallying.

And when there is a rally, the market will seem to go straight up, and then straight back down to lower lows in the days that follow. This mad-hatter routine can drive disgusted and inexperienced investors out of the market, never to return. But what is destruction and economic ruin for some can now be opportunity for the investor with cash.

For the following comments, refer to this weekly chart of the SPX 500 from October 2008 to April 2020, with the indicators (below). Follow along as I explain each indicator on the charts.

1. Near a bear-market bottom, the Average True Range [ATR] will be at ~100 or above. This indicator measures daily percentage swings in the market. When price discovery is uncertain, the index will swing wildly up and down in 3%-4% moves in a short amount of time. These swings are caused by panic selling. In bear markets, such wild daily swings are du jour, but March 2020 was the worst example in stock market history.

The Dow Jones Industrial Average had a cumulative absolute percentage change of 117% in March 2020... With only 22 trading days in the month, that is an average absolute daily change of a whopping 5.3%. The next highest month (Oct 2008) only had an average absolute daily change of 3.8%. (The Craziest Month in Stock Market History, by Nick Maggiulli, April 1, 2020)

2. Volume will be at least 2.0 x normal

3. Williams % R (set at 52 for weekly chart) will be close to - 90%.

4. The VIX Velocity Index (aka the "fear gauge") will rise above 40 in a shear spike. Investors use the VIX to measure the level of risk, fear, or stress in the market.

5. The percentage of SPX stocks above their 200-day SMA will fall 2+ standard deviations below normal.

See daily chart: S&P 500 Percent of stocks Above 200-day moving average ($SPXA200R)

Corrections (within a bull market) will dip to +/- 20%. Severe corrections will fall to +/- 10%

In March 2020, during the financial crisis of 2008-09, and the long bear market in 2002-03, this percentage dipped below 5%. Such readings are extreme and should be bought in every case. Each one of these extreme occurrences signaled the relative bottom of those bear markets.

In 2002-03 there were several months of failed rallies after the original (-96%) mark, but the effect of these rallies on the original buy point was negligible. The same was true in 2008-09. The lows in November 2008 through March 2009 spanned three months, and the March 2009 low was a little lower than the November 2008 low, but in the larger scheme of the 11-year bull market that followed, the effect was de minimus.

While other investors are questioning, "Is the bottom in?" this single measurement will tell you when the market direction is soon about to turn. When the SPX has been bought at one of these watershed moments and held throughout a bull market, the long-term compound annual growth rate [CAGR] has been 10.82% (2000 to 2020).

Coming out of a Bear Market

1. New applications for unemployment insurance will fall for the first time since the bear market began. To verify past history in this link (above), use these dates: 1967-01-07 to 2020-03-12. The sudden skew of 7 million unemployment claims in March/April 2020 (during the coronavirus pandemic) renders the long-term graph almost indecipherable. For the most recent months, use these dates: 2020-01-07 to 2020-05-05.

In the weeks leading up to a recession - and at the end of a long period of economic expansion - new unemployment claims will lie at the very lows of the cycle. But in the opposite circumstance, a peak in new unemployment claims will signal the end of a recession (and the end of a bear market).

A positive turn in the market occurs rapidly the first-time claims recede. In 2009 and 2020, new unemployment claims for both years peaked the week of March 28.

2. The SPX 500 crosses above its 50-day moving average, confirmation of the previous buy signal at the bottom

3. The SPX crosses above its downward sloping 100-day and then 200-day moving averages.

4. The golden crossover of the 50-day SMA above the 200-day SMA is confirmation that a new bull market has begun.

5. A final indicator of recovery is the 50% retracement off the lows. Larry Williams posits that this is when the market will not turn back on itself, and is ready to move to higher ground. In his video, Are We On The Eve Of Destruction?, he gives 20 out of 20 examples where the 50% mark heralded the beginning of a next leg higher.

The market is at that point now.

Forward Analysis

I do not expect a return to the March 23 lows. Virtually every indicator of a bear market bottom has passed the test, and improbable as it seems to many investors, the long-standing secular bull market that began in March, 2009 remains with us and is about to renew.

I will say in closing that the heroes of the "next leg up" could be those most brutalized by this downturn: the travel and lodging sector. A great business lesson is learned when your back is literally to the wall and 80% of your company's capitalization has vanished. It happened to Microsoft (MSFT), Intel (INTC), Amazon (AMZN), eBay (EBAY), and the semiconductors after the dot-com crash: to the homebuilders, mortgage REITs, and banks after the financial crisis; and it has happened to the travel and lodging sector in March 2020. Those who suffered this in the past today are some of the strongest, best-capitalized companies in the SPX 500. And when those cruise lines again embark after this pandemic passes, they will be the cleanest, safest places you could sail.

What to buy at the bottom of the market? And if you have missed out, what to buy now?

There are several different ways to approach this, but the most important thing for me is the solidity of the earnings and the stability of the company before the downturn.

Small-cap value stocks can double, even triple, off the lows of a bear market. I like to choose out-of-favor value stocks that have been mispriced in sell-offs. Bill Miller, the legendary investor, formerly of Legg Mason (LM), has utilized this strategy for most of his career, and he has the longest record of beating the SPX 500: 15 consecutive years.

I get lots of ideas by reading the feature stories in SA. That is how I discovered half the names below. I am currently invested in an American home-builder specializing in California real estate (TRI Pointe Group (TPH)); a luxury resort hotel chain REIT (Park Hotels & Resorts (PK)), a cruise line (Norwegian Cruise Line (NCLH)), the new Carrier air-conditioning spin-off (Carrier Global (CARR)), the natural gas MLP (ONEOK (OKE)), and the Residential Real Estate REIT (Annaly Capital Management (NLY)).

I fully expect an eventual double with the hotel REIT and the cruise line, and new 52-week highs with the homebuilder. Tri-Point's recent earnings call showed very little - if any - effect from the downturn on new homeowners qualifying for their homes. They beat on revenues and EPS, and their quarter included some of the worst weeks of the sheltering in place.

There is a chronic, severe shortage of affordable housing in California. It's so bad that the state legislature has passed laws to prevent municipalities from hindering residential development, especially adjacent to transit hubs. Before the recent pandemic, the CA economy was the strongest it had been in decades, creating thousands of high-quality jobs in technology, business innovation, and entrepreneurship. Those people are still buying homes.

I am holding the two REITs (OKE and NLY) for the long term because I think their dividends - skewed higher by the recent sell-offs in mortgage REITs - will remain a permanent feature of those names as long as I reinvest them.

There are lots of tier-two and tier-three names in the small-cap sector which remain 50% to 60% below their February highs, many of them in the REIT sector.

For example, Anally Capital Management recently had a stellar earnings call. They have paid their dividend, said that the downturn had given them the opportunity to reduce leverage and raise cash for new opportunities. There were no significant losses in their divisions, and 90% of their portfolio of mortgages is agency RMBS, fully backed by the federal government.

Their book value has increased about 7% in just the month of April to $8, and with short-term rates at zero, it will reduce their need for hedges. As long as the slope of the yield curve remains somewhat vertical, the spread between short-term and long-term rates should yield the company some nice earnings on interest spreads. There is also now the first certainty surrounding federal funds rate in almost two years. All this bodes well for the REITs. Annaly is trading 25% below book value, and the CEO just bought a 100,000 shares on the open market at $6.03. The current dividend is 16%, which looks sustainable. There is both a capital gain and nice interest income possibility here.

Of all my new holdings, the one I feel the most confident in is Park Hotels. The company owns 60 luxury hotels in prime legacy locations in major business and recreation centers in the US. The shares are trading for $8. The average analyst target is $16. The stock was $23 on February 18, 2020.

By my estimate, they have $4.70/share in cash and credit, with no major debt maturities until the end of 2021. The interest payments on their $1 billion revolver are an average of 2.64%. Of their 60 hotels, they own a square block in Midtown Manhattan in New York City; another three hotels at Union Square and NorthPoint in San Francisco, prominent hotels in Waikiki and Kona. I think those six hotels alone are easily worth a net billion dollars, or $4/share after a sale.

There will be an earnings announcement on Monday morning, May 11, in which more will be revealed about the monthly cost of their lockdown this spring. In March 2020, insiders bought $1.7 million in shares (including just under a million shares by the CEO at $12.52) with options on an additional 184,037 shares.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of CARR, TPH, NLY, OKE, NCLH either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.