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Editor’s Note: Today we’re bringing you a guest editorial from TradeSmith Chief Research Officer and TradeSmith Decoder Editor Justice Clark Litle. We think you’ll appreciate his research and analysis. Keith will be back on Monday with more of his market insights.
Stocks are headed for a bear market. The odds of this are overwhelming now — as in better than 90% — and there is no point in hoping or wishing otherwise.
The Federal Reserve will have to raise interest rates until the threat of entrenched inflation recedes. This means tighter monetary policy, reduced liquidity, and an economic downturn or full-blown recession that harms the corporate earnings outlook, creating conditions for a bear market.
There is no way around this; inflation at 40-year highs will not disappear automatically, and inflation is now the No. 1 concern and pain point for American voters. The University of Michigan consumer sentiment index fell to a 10-year low this month because of inflation, with sentiment levels comparable to those of the Great Recession post-2008.
The Federal Reserve has to do something about that, and just as importantly, the Fed has to take action to preserve its reputation as an inflation fighter.
These imperatives mean a hiking cycle is coming, and the hikes are going to hurt. Indeed, hiking until it hurts is part of the point, because the only real way to throttle back inflation when it gets serious is to slow down the economy.
Meanwhile, investment adviser Gary Shilling points out that the Federal Reserve has gone into a hiking cycle — an extended period of raising interest rates — a dozen times since the 1950s.
When the Fed does this, it generally tries to engineer a “soft landing.” A soft landing is Wall Street speak for a gentle economic outcome where, even though interest rates are rising, the economy avoids a downturn or a recession.
But according to Shilling, 11 out of 12 times since the 1950s, the Federal Reserve failed to get a soft landing and created a “hard landing” instead.
A hard landing is what happens when the economy experiences a downturn or recession, which in turn deteriorates the corporate earnings outlook — which then creates conditions for a bear market, as average earnings-per-share and average price-to-earnings multiples simultaneously shrink.
Even with a normal hiking cycle, the odds of avoiding a downturn or recession are very low (one out of 12 since the 1950s). And this time around, the situation is anything but normal.
To preserve credibility and soothe the pain of American voters, who are deeply upset about the inflation hit they are taking, the Fed is going to hike until it hurts, and the stock market will be sacrificed.
Because of this reality, a bear market looks inevitable now, and the yield curve (a bond market metric that predicts downturns and recessions) is starting to price this in.
So a bear market is coming, and the Federal Reserve will not stop it because stopping inflation is more important, and the Federal Reserve can’t fight inflation and prevent a downturn at the same time.
Wall Street Analysts Are Dangerous in Bear MarketsBut what does that mean for you?
For one thing, the arrival of a multiyear bear market — in which stocks generally could lose 30% to 50% of their value, or even more when adjusted for inflation — means your retirement could be at risk. If you are too young to worry about retiring, the investment gains accumulated over the course of the outgoing bull market could be at risk.
You should know, too, that Wall Street analysts can be dangerous in bear markets.
This is because, in a bull market, mediocre analyst advice can result in positions that go sideways or rise more slowly than the market — which is frustrating but not dangerous — whereas in a bear market, that same advice can result in positions that grind lower for months or years on end, destroying capital and wrecking portfolios along the way.
Worse still, in the grips of a bear market, Wall Street analysts have a tendency to recommend “buying the dip” on stocks that are going down.
And then, when the picks they recommend fall further, these analysts do not change their tune. Instead, they double down and recommend buying more, which leads to larger downside exposure and larger investor losses when the stock continues to fall.
Why do most Wall Street analysts do this? Why do they tend to keep recommending stock ideas that are declining in price, while refusing to acknowledge that bear market conditions exist?
It is partly due to an observation made by Charlie Munger and others: “To a man with a hammer, everything looks like a nail.”
Far too many investment analysts specialize in a small handful of industries, or a particular area of the market like technology and growth stocks, and then narrow their scope further by only focusing on the long side (with no inclination or ability to go short).
As a result of this intense specialization, these analysts have a hammer that says “look for stocks in sector XYZ or industry ABC that might be a buy.”
And because the hammer is the only tool they have, all opportunities look like nails — that is to say, the analysts only make long recommendations in the sectors or industries they favor, even when the broad market outlook is as bearish as it gets.
The Rule: Don’t Buy Stocks Below the 200-Day Moving AverageYou can guard against this danger with a simple rule of thumb: Do not buy stocks below the 200-day moving average.
The 200-day moving average is widely observed by investors and traders alike. Many consider it the ultimate dividing line between bullish and bearish territory, meaning that if a liquid asset is trading above its 200-day moving average, the asset should be given a bullish benefit of the doubt, whereas an asset trading below its 200-day moving average should be viewed with a bearish lens.
It isn’t clear why the 200-day moving average emerged as a bullish-bearish barometer and not some other length of moving average. But for whatever reason, it has become a kind of observational standard, like the QWERTY layout for Western keyboards.
It may have initially gained popularity because 200 days is a healthy length of time, representing about 80% of a trading calendar year (there are about 250 trading days in a given year). The 200-day period is long enough to cover a significant period of time but short enough to respond to trend changes (as the average will rise or fall on a lagged basis in line with the overall trend).
The investor who says “no” to buying stocks below the 200-day moving average — not on a case-by-case basis, but as an automatic rule — accomplishes multiple things in a single step:
- With this simple rule, the vast majority of stocks destined to lose money in a bear market are instantly ruled out. The analysts’ calls that result in losing money from buying sub-200-MA stocks are also ruled out. This can save a significant amount of time by reducing the initial filter to a single question: “Is this stock above its 200-day moving average?” If the answer is “no,” the stock is a pass.
- Saying “no” to stocks below the 200-day MA is an easy way to be humble. In order for a stock to fall below its 200-day moving average and stay there, other investors have to be motivated sellers. (If they weren’t, the price would not be below its 200-day in the first place.) Do you really know why the motivated sellers are selling? Perhaps they know something you don’t, or perhaps the stock has problems you aren’t aware of. Saying “no” to sub-200 MA stocks is a way to say, “I don’t know why this stock is weak, but I’m taking a pass on the hidden risks.”
- Focusing on stocks that are above the 200-day MA — the natural inverse of this rule — is a good way to keep one’s focus on winning sectors and industries. There are always industries that can do well even in the midst of the worst bear markets. There were stocks and industries that gained value in the 1930s in the midst of the Great Depression. What is a simple step for honing in on these industries? Paying attention to the 15% to 20% of stocks and industry groups trading above their 200-day moving average when 80% to 85% of the market is trading below.
Two Specialized Exceptions to the RuleAre there exceptions to the 200-day moving average rule of thumb? Are there instances or scenarios where it makes sense to buy stocks below the 200-day?
The answer is yes, but the two main exceptions to the 200-day moving average rule each require specialized expertise:
- Value investors who are skilled at reading balance sheets can sometimes identify extreme values in the midst of bear markets. This is the equivalent of buying dollar bills for 50 cents, with classic examples being Warren Buffett’s purchase of Washington Post stock in the mid-’70s or Coca-Cola stock after the crash of 1987.
- Traders who are skilled at recognizing outlier price moves — for example, in the aftermath of a crash — can sometimes identify excellent reward-to-risk buying opportunities where the buy is accompanied by a defined risk point. TradeSmith Decoder, for example, took large long positions in Bitcoin and silver within days of the March 2020 panic lows, when the Federal Reserve made clear it was unleashing a flood of new quantitative easing (QE) measures that would drive risk assets higher.
Value investors with this kind of conviction can buy publicly traded companies at large discounts to intrinsic value — with quotations trading far below the 200-day moving average — because they know exactly what they are buying and why, and also because they have the fortitude to hold the position through adversity.
With the trading exception, the key is understanding the situation that caused the outlier price move, and also knowing the likely cause by which prices will rebound. Then, too, buying after an outlier price move requires a defined risk point for the position so the trader can exit with a limited loss if their analysis or timing is off.
Apart from those two exceptions — both of which require specialized skill sets — there is almost no reason to ever buy stocks below the 200-day moving average, in our view.
By the way, the 200-day rule works well in bull markets too: If thousands of stocks are trading above their 200-day average (a normal state of affairs in bull market conditions), why buy the ones that aren’t?
You, as the investor, have no restrictions that require you to focus on stocks that are below the bull-bear waterline of the 200-day moving average, and you are the one putting your hard-earned investment dollars at risk.
Given that reality, and the fact that an incoming bear market looks inevitable now, we urge consideration of this simple rule of thumb: Don’t buy stocks below the 200-day moving average. It’s an effective means of protecting your capital in challenging conditions.