We reviewed the first 10 bear market signposts in a previous article. This article will look at the next few. Remember that, of the first 10, I felt 3 were irrelevant. The 11th signpost is triggered when the net percentage of consumers who think stocks will move up is above 20%. Since stocks move up about 70% of the time, I think such bullishness is low, but it’s the way the poll has always been oriented. Plus, most consumers don’t know that stocks go up that often. Either way, when the Conference Board’s survey, which shows the net expectation consumers have that stocks will go up, is above 20%, it has a 100% hit rate of being triggered within six months of a bear market going back to 1987. It has been triggered now because consumers are very optimistic about stocks as they suffer from recency bias. The longer the bull market lasts, the more bullish they are. This phenomenon may also occur because when bull markets are old, the employment rate is the highest.

Another aspect to keep in mind is that consumers might be more intelligent than in the past because of the advent of the internet. One example of their intelligence is the movement towards passive ETFs instead of staying with underperforming mutual funds. There are a couple aspects to this shift. The first is many mutual funds can outperform the market, but with their fees, they underperform the market. By switching from active to passive funds with low fees, investors are being smart consumers.

The second aspect is that this market cycle has been one which active managers can’t find alpha. By getting out of active funds now, it is a short term urge to get out of an underperforming business right at the end of the cycle. The fact that consumers know that these funds are performing poorly shows they are focusing on their returns instead of mindlessly throwing away the quarterly performance note. However, they may lack the foresight and historical framework to understand that active underperformance is cyclical. As you can see in the slide below, there has been little alpha lately. Alpha comes and goes with the market cycle, so completely abandoning the active strategy doesn’t necessarily make sense. My goal with this point is to show the perspective that there are cyclical and secular trends when it comes to the active versus passive discussion. Both are moving towards passive, but a changing market could mean the cyclical shift is near its end. The secular headwinds can become tailwinds at some point if the passive funds provide opportunities for stock pickers since passive funds don’t research names individually.

Earnings Beats Don’t Provide Good Returns

The 12th signpost is a new one as it has only existed since 2000. It has a 100% hit rate, but there have only been a couple bear markets since then. The signpost is triggered when stocks which beat their earnings and sales estimates outperform the market by less than 1% in one of the past 3 quarters. The latest result is an outperformance of 1.2%, but this signal was triggered by another quarter. This is a new phenomenon plays into the point about passive investing as some are blaming low returns on earnings beats on ETFs. The other point worth noting is that earnings beats aren’t really beats. In the past couple decades, analysts and management teams have gotten together to ensure estimates are lowered so they are easily beat. Sales beats still have meaning, but guidance and other parts of reports also play a role in how stocks perform. Therefore, I think this signpost is interesting, but not old enough to be considered a viable warning sign.

Sell Side Not Optimistic

The 13th signpost is slightly unclear. It’s either when sell side analysts have buy ratings on more than 63% of stocks or when their price targets are higher than the current price of more than 63% of stocks. Either way, the point is that when sell side analysts are very bullish, it means that stocks are probably getting overextended. This signpost has been 6 months in front of every bear market since 1987. Because analysts are only bullish on 56.1% of stocks, this signpost hasn’t been triggered. The lack of optimism by sell side analysts is a point I’ve discussed recently. I mentioned that I think they will raise their price targets soon because of the tax cuts. I also said stocks would price in the tax cuts before analysts got around to raising their targets. This mean sell side research can be a top signal, just like this signpost list suggests.

Fund Managers Not All In Yet

Even though consumers are very optimistic on stocks, the buy side hasn’t drunk the Kool-Aid  yet. With a multitude of charts showing that cash positions are low, it’s surprising to see that the buy side doesn’t have a low enough cash position to meet the threshold where the bear market trigger is checked off. The threshold is below 3.5% cash, but they have 4.4% cash. This signpost has been checked off before every bear market since 2001. Although that’s not a long time, I think this is a viable metric because it shows how heavily invested the managers who control the market are. Because they have a 4.4% cash cushion, there might be more room for the market to rally.

Conclusion

I’ve reviewed 14 of the 19 signposts so far. Four of them aren’t viable in my opinion. If you take out the ones I don’t like it means that 8 of 15 indicators have been triggered. That assumes the five remaining indicators which I haven’t reviewed yet are viable. I will review the final signposts in my next article.

The shift from active management to passive might slow down or reverse next year because of the changing market dynamic with an increase in equity volatility and more inflation coming. The goal for active management is to protect investors’ money in times of stress. Sometimes they fail at their jobs, but it doesn’t mean the industry shouldn’t exist. It means the ones with poor performance should go out of business, while the good ones should stay in business.