This quote famously attributed to Mark Twain resonates when looking at stock market cycles. Historically, the US stock market has exhibited similar patterns and characteristics as it transitioned from an uptrend (bull market) to a downtrend (bear market). What do these patterns look like and where does the data point to now?
Most major bear markets begin in a similar fashion. First the smallest, most speculative stocks (small capitalization companies) fall out of favor with investors and begin to turn lower. If an economic downtrend is coming, they will be most affected as the durability of their business models and customer bases will be put to the test. Then typically the deterioration migrates further up the food chain into the mid capitalization companies. While more insulated than the small cap segment, these companies are not yet considered “Blue Chips” and therefore see capital flee when the outlook darkens. Finally, the last ones standing are the large cap companies among which you will find the “Blue Chips.” These are companies that have withstood multiple economic cycles, possess global customer bases, and maintain easy access to capital. Some of these are the current “darlings” of the market.
Despite the weakness under the surface, the major market indices continue to advance because investors are crowding into a small group of large cap stocks that keep the major averages at or near new high levels. When the selling finally hits these stocks, the bear market is in full swing. By the time the bear market becomes obvious, it is too late as many stocks have already declined substantially. A broad recovery will only occur in the next bull market cycle which will take time to play out.
The classic definition of a bear market in stocks is a decline of at least 20% or more from its yearly (52 week) high. As of early March, the percentage of small cap stocks at least 20% below their high is elevated at more than 50%. When the S&P 500 made its most recent all-time high in early January, 40% of small cap stocks were already in a bear market. At the end of February, the percentage of mid cap stocks down 20% or more stood at over 35% percent, up from 10% in November. Finally, the percentage of large cap stocks down 20% or more has surged from just 7% in early February to 25% by the end of the month.
Another way to look at the health of the broader markets is by observing the percentage of index constituents trading above their 200-day moving averages (MA). The 200-day MA is a widely used gauge of the long-term trend. If a stock is trading above the 200-day MA it is considered to be in an uptrend (bull market) and vice versa. Early last September, the percentage of stocks in the S&P 500 Index (approximately 500 of the largest companies in the US) trading above the 200-day dipped below 80% and has been steadily declining since. When the S&P 500 touched a new all time high level in January, less than 80% of the stocks in the index were in an uptrend. Here in early March, the S&P 500 has deteriorated substantially with less than 40% of stocks in the index in an uptrend. The NASDAQ Composite index exhibits very similar characteristics.
S&P 500 Index – (1-year Daily Chart) with percent of constituents trading above their 200-day Mov. Avg.
NASDAQ Composite Index – (1-year Daily Chart) with percent of constituents trading above their 200-day Mov. Avg.
Deterioration in equity markets began in the summer of 2021 and has broadly intensified in 2022 exacerbated by the war in Ukraine. With so much damage having already occurred, it is wise to maintain a defensive posture until market internals exhibit favorable odds for a sustained advance. The few sectors that remain in an uptrend at present are energy, consumer staples, and utilities. While it is futile to attempt to predict the future, being defensive when the market exhibits unfavorable odds is the prudent course.