Volatility is a bear market signal

By David Schwartz 11:36 6- Dec -2007

The FTSE-100 turned in a sizzling gain of 178 points on December 5. It may seem odd to issue a bear market warning immediately after such a spurt. But huge inter-day price swings of recent weeks warn UK investors to proceed with caution. 

Virtually anyone can spot a bear market late in the day after blood has already been spilled. But spotting a downturn near its beginning, before much of the damage has occurred, is a tougher row to hoe.

Investors were slammed by a steady flow of unsettling business and economic news in recent months. Much of it is linked to the US financial sector (including sub-prime lending and an illiquid derivatives market) plus an expanding real estate crisis. Our own local Northern Rock crisis is one of the casualties of this American problem.

Will the UK stock market eventually tumble into bear market territory? No one can answer the question with certainty due to one important unknown. We do not know if the current batch of US economic crises will remain ring-fenced within financial and real estate segments of the economy, or if they will spill over to the broad US economy. If spill-over does occur, investors on both sides of the Atlantic will probably suffer a bear market.

"Spill-over" is the £64,000 question that some of the finest economic brains on the planet are currently grappling with – perhaps $64 trillion is more accurate figure. At present, no one knows how events will turn out.

Unfortunately, the stock market often reacts well in advance to the arrival of accurate economic news. This is why bull market advances often start while everyone is so frightened and, for that matter, why bear market downturns kick off while economic conditions appear to be so sunny.

The bottom line: Using economic indicators to predict bear markets is not an effective forecasting approach. By the time the economists have had their say, gallons of red ink have already flowed.

In the absence of useful economic indicators, here is one historical relationship that has turned in a very credible record in the last few decades for predicting bear market

History teaches that a sudden flurry of big daily price swings (up as well as down) in excess of one per cent is consistently linked to bear markets.

There were eight periods since 1971 when shares shifted in excess of one per cent at least 20 times within 40 consecutive trading days. It is not common knowledge but a bear market was running in seven of those periods. They ranged in pain from just 21 per cent in 1981 to a 73 per cent smash in 1972-74.

The single exception to the rule occurred in 1977 when the stock market fell 16 per cent. If we factor in the effects of a double-digit inflationary spike that existed during this period, the dip would have been around 17 per cent in real terms - a bear market near-miss according to most stock market statisticians.

Our graph shows the four most recent painful stock market dips tipped off by this indicator: in 1981, 1987, 1998 and 200-2003. Computer screen size limitations prevent us from illustrating the full four-decade period.

We are currently experiencing the ninth spurt of abnormally high inter-day volatility in modern times. No guarantees of course but if history is any guide, the bear market of 2007 is now underway or shortly will be.