Two weeks ago, Bank of America tripped recession-watcher alarms, when it announced out that one of its surest bear-market indicators, one which has never had a false negative, had just been triggered. As we said at the time, according to BofA's Savita Subramanian in November the S&P 500's three-month earnings estimate revision ratio (ERR) fell for the fourth consecutive month to 0.99 (from 1.03), indicating that for the first time in seven months, there were more negative than positive earnings revisions, needless to say a major negative inflection point in the recent surge in profits.
Why was this significant? Becase as BofA explained, the three-month S&P 500 ERR has been used by the bank as one of its 19 key "bear market signposts", and with the one-month ERR falling below 1.0 for the second time in six months, this marks the trigger for the 11th bear market signpost. BofA's ERR rule is triggered when, over a six-month window, all of the following criteria are met: 1) the one-month ERR falls from above 1.0 to below 1.0; 2) the one-month ERR is below 1.0 for two or more months; and 3) the three-month ERR falls below 1.1 for at least one month. Incidentally, the hit rate of the "ERR" bear market indicator, meaning its historical accuracy in predicting a bear market is 100%, the only question is how long it takes. The last time this trigger was set was mid-2003, and here is the punchline from Bank of America:
Since 1986, a bear market has followed each time that the ERR rule has been triggered. While individual signposts may not be useful for market timing (this one was triggered several years too early in the last two cycles), prior bear markets were preceded by a broader array of signals having been triggered.
This is shown in the chart below:
Ok fine, one indicator has been tripped. What about the rest? Well, as BofA reports in its just released Investment Strategy slidepack, its latest list of bear market signposts shows that as of this moment, 11 of 19 signals have been triggered at this point. That's the bad news; the good news is that at least 80% were triggered ahead of the last seven bear markets.
Here is the breakdown:
Specifically, the following indicators have now been triggered:
- Bear markets have always been preceded by the Fed hiking rates by at least 75bp from the cycle trough
- Minimum returns in the last 12m of a bull market have been 11%
- Minimum returns in the last 24m of a bull market have been 30%
- 9m price return (top decile) vs. S&P 500 equalweight index
- Consensus projected long-term growth (top decile) vs. S&P 500 equalweight index
- We have yet to see a bear market when the 100 level had not been breached in the prior 24m
- Similarly, we have yet to see a bear market when the 20 level had not been breached in the prior 6m
- Companies beating on both EPS & Sales outperformed the S&P 500 by less than 1ppt within the last three quarters
- While not always a major change, aggregate growth expectations tend to rise within the last 18m of bull markets
- Trailing PE + CPI y/y% >20 in the prior 12m
- Based on 1- and 3-month estimate revision trends; see footnote for more detail
And here are the 8 indicators that have yet to ring the proverbial bell.
- Each of the last three bear markets has started when a net positive % of banks were tightening C&I lending standards
- Companies with S&P Quality ratings of B or lower outperform stocks rated B+ or higher
- In the preceding 12m of all but one (1961) bull market peak, the market has pulled back by 5%+ at least once
- Forward 12m earnings yield (top decile) vs. S&P 500 equalweight index
- A contrarian measure of sell side equity optimism; sell signal trigged in the prior 6m
- A contrarian measure of buy side optimism
- Does not always lead or catch every peak and all but one inversion (1970) has coincided with a bear market within 24m
- Market peaks have come after the VIX >20 at some point in the prior 3m
And while more than half of BofA's bear market triggered being triggered sound ominous, the following chart shows that on a historical basis, the minimum threshold for a bear market onset was no less than 80% of the signposts "flashing red."
Which means that the bear market may or may not be imminent. So how should one trade this clearly overvalued market? Well, as Bank of America concedes, we are in a stage when fundamentals no longer matter. What does? Momentum.
Our US Regime Model, a quantitative framework for stock-picking, suggests we are in the mid to late stages of the market cycle and in this stage, momentum is the best way to invest. As contrarian value investors, this is not an easy call to make. But if this bull market is closer to over, our analysis of factor returns indicates that late-stage bull markets have been dominated by stocks with strong price momentum and growth, while value, analyst neglect, and dividend yield have been the worst-performing factors.
In other words, buy whatever everyone else is buying, just be sure to sell before everyone else sells. Good luck.