A model of the rise and fall of the US stock market

Financial markets around the world have been trading in the possibility of a U.S. recession for the past week, with prices of everything from crude oil to copper to just about every industrial metal plummeting. Everyone is talking about how deep the recession is likely to be, how long stocks will fall, how the Federal Reserve will react…

Mr. Market, it’s so fickle.

Less than a month ago, the market was abuzz with talk of $200 oil, 75 basis points every time the Fed raised interest rates, and at least 4% for 10-year Treasury yields…

At that time, I made a blank stare and told you firmly:

Don’t wait, this is the Iron top!

Come to think of it, a couple of months ago, I was looking at that bull bear indicator invented by Goldman Sachs and watching that bear indicator hit record highs as U.S. stocks rallied…

What is a bull – bear indicator?

In September 2017, Goldman Sachs put out a report called:

The Bear Necessities

What it did was analyze the 30 major stock market crashes of the past 200 years and try to find the biggest commonalities among them.

The report analyzed 40 macroeconomic, market and technical indicators, and found that no one indicator is a surefire indicator that a bear market is imminent. But there are some indicators that are very indicative — macroeconomic, for example, bear markets generally occur in environments where growth is slowing, stocks are expensive and central banks are about to raise interest rates.

To that end, the report offers five necessary indicator anomalies for an impending crash:

1) Valuation level (generally represented by Sheller PE)

If the stock market is low, it can’t fall much, so high valuations are a necessary condition for a big fall; but the reverse is not true — high stock market valuations do not necessarily lead to an immediate crash, and high valuations can last for a long time.

2) Unemployment rate

If the economy suffers a recession and corporate profits are hit, the unemployment rate is bound to rise significantly. Therefore, before the stock market falls, the unemployment rate must have a process of continuous decline and even stability.

3) Inflation rate

Rising inflation usually signals the end of a boom cycle and can prompt central banks to tighten monetary policy, raising the cost of financing the economy and causing a recession and bear market — but since central banks’ manipulation of interest rates lags behind real interest rates in the economy, stocks usually fall when inflation rises, and inflation peaks are a lagging indicator of declines.

4) ISM PMI index

ISM stands for “Institute of Supply Management”, and its monthly manufacturing purchasing managers’ index (PMI) represents the state of the production sector of the US and the global economy. When the PMI index starts to fall from the peak, it usually means that the economy starts to deteriorate. The outlook for corporate earnings could turn out to be a very typical leading indicator of the economy.

5) The yield curve

I have popularized the concept of the “yield curve” many times before. Before the stock market falls, there is usually a flattening of the yield curve — medium – and long-term interest rates (10-year Treasury yields) and short-term interest rates (two – and three-month Treasury yields) begin to approach or even invert. It is usually short-term Treasury yields that start to rise in the face of central bank rate hikes, while safe-haven flows into mid – and long-term Treasury bonds cause yields to stabilize or fall. The flattening of yields will deprive commercial banks of the incentive to supply credit to the economy, indicating a short-term economic slowdown and a possible plunge in the stock market.

In 2019, Goldman added another metric to the report:

6) The balance of payments in the private sector, which measures the risk of financial overheating by calculating the difference between the income and expenditure of households and enterprises.

Then, take the average of the historical percentiles of each of these six indicators to get a bull market indicator. Here’s a chart of Goldman’s bull and bear indicators from 1955 to 2020.

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Generally speaking, if the risk index is higher than 60%, the risk of retracement will increase significantly. The higher the risk index, the greater the retracement amplitude usually If the peak (usually more than 70%) is reached, it basically means that a big fall is imminent. When the risk index is below 40%, the stock market is more likely to rise and the lower the value, the more room for the stock market to rise.

Using these indicators and methods, I made statistics and analysis on the data since 1980, and the results showed as follows:

From November 2021 to March 2022, the bull bear index consistently exceeded 80% and reached a record high of 87%.

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This means that the U.S. stock market in March 2022, there is a very high downside risk.

Since April 2022, as U.S. stocks have continued to decline, the bull bear index has also fallen, but remains near record highs.

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In addition to predicting the stock market, the bull market indicator is also a good indicator of whether the U.S. economy will fall into recession.

Looking at the six recessions since 1980, we can see that each recession occurred when the bull bear index peaked and gradually declined from its high. Only the bull bear index peaked and fell in the second half of 2018 (from a high of more than 70 percent) without a recession. But then the global pandemic crisis of early 2020…

On this measure, there is a high probability that the U.S. economy will fall into recession, but not immediately.

As for whether the US stock market will tumble, this may involve a different question –

To what extent is the current decline in US stocks factored in a recession?

Recently, I have been doing a series of courses on financial investment, in which I designed a model to track the rise and fall of the US stock market. It turns out that in the short term, if the economy doesn’t fall into recession before the end of the year, the models even suggest that stocks are a bit overdone.

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