Over the past 45 years, the stock market has lost more than
20% each time three warning signs flashed simultaneously. After a selloff this
past week dragged the Dow Jones Industrial Average into negative territory for
the year, it's worth noting that all three are flashing today. The signals are
excessive levels of bullish enthusiasm; significant overvaluation, based on
measures like price/earnings ratios; and extreme divergences in the
performances of different market sectors.
The S&P 500's average subsequent decline on those
earlier occasions was 38%, with the smallest drop at 22%. A bear market is
considered a selloff of at least 20%, with bull markets defined as rallies of
at least 20%. In fact, no bear market has occurred without these three signs
flashing at the same time. Once they do, the average length of time to the
beginning of a decline is about one month.
The first two of these three market indicators—an
overabundance of bulls and overvaluation of stocks—have been present for
several months. For example, as long ago as December the percentage of advisers
who described themselves as bullish rose above 60%, a level Investors
Intelligence, an investment service, considers "danger territory."
In addition beginning late last year, the price/earnings
ratio for the Russell 2000 index of smaller-cap stocks, after excluding
negative earnings, rose to its highest level since the benchmark was created in
1984—higher even than at the October 2007 bull-market high or the March 2000
top of the Internet bubble. The third of bearish omens emerged just recently
when the fraction of stocks participating in the bull market, which already had
been slipping, declined markedly.
One measure of this waning participation is the percentage
of stocks trading above an average of their prices over the previous four
weeks. Among stocks listed on the New York Stock Exchange, this proportion fell
from 82% at the beginning of July to just 50% on the day the S&P 500 hit
its all-time high.
Another sign of diverging market sectors: When the S&P
500 hit its closing high on July 24, it was ahead 1.4% for the month, in
contrast to a 3.1% decline for the Russell 2000. The loss of between 13% and
20% for the S&P 500, less than the 38% average decline following past
occasions when the unfavorable indicators was present.
Also among the hardest-hit stocks during a decline will be
those with the highest "betas"— in particular—and technology stocks
generally are those with the most pronounced historical tendencies to rise or
fall by more than the overall market. The consumer-staples sector has also held
up relatively well during past declines.
If the broad market's loss is in the 13%-to-20% range and
you have a large amount of unrealized capital gains in your taxable portfolio,
you could lose in taxes what you gain by selling to sidestep the decline.
However, the larger losses anticipate for smaller-cap stocks could be big
enough to justify selling and paying the taxes on your gains.
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