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Bear market alert: five critical signs

JP Morgan global market strategist Mike Bell highlights five crucial warning signs the bear market could be on its way.

What's in the tea leaves

With the FTSE giving up all its gains for this year after Theresa May's shock decision to call a snap-election and French elections around the corner, how fearful should investors be?

Prior the recent volatility, shares continued to ratchet higher in what is an aging bull market. While they could keep on rising, some investors fear that the age of this recovery is increasing the probability of a bear market in the near term, notes JP Morgan Global Market strategist Mike Bell (pictured).

'With the so-called "Trump trade" waning and US equities in particular looking expensive, it may be only natural for investors to consider taking profits,' Bell adds.

However, he warns that prematurely giving up on the bull market could be costly in terms of lost upside potential.

So what should one look for in the tea leaves as warning signs the next bear market is coming? Bell highlights five US-centric charts - which are also very relevant for Europe - as crucial indicators.

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What's in the tea leaves

With the FTSE giving up all its gains for this year after Theresa May's shock decision to call a snap-election and French elections around the corner, how fearful should investors be?

Prior the recent volatility, shares continued to ratchet higher in what is an aging bull market. While they could keep on rising, some investors fear that the age of this recovery is increasing the probability of a bear market in the near term, notes JP Morgan Global Market strategist Mike Bell (pictured).

'With the so-called "Trump trade" waning and US equities in particular looking expensive, it may be only natural for investors to consider taking profits,' Bell adds.

However, he warns that prematurely giving up on the bull market could be costly in terms of lost upside potential.

So what should one look for in the tea leaves as warning signs the next bear market is coming? Bell highlights five US-centric charts - which are also very relevant for Europe - as crucial indicators.

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Chart 1: Jobless claims

'This chart shows the relationship between US initial jobless claims (the number of people who lost their job and filed for unemployment benefits for the first time, during the past week) and the S&P 500, the main index for US shares.

'Going back to the 1990s, there is a very tight pattern – shares go downwards as the trend in initial jobless claims rise. Job losses are bad for confidence and the economy and shares quickly feel the impact.

'Importantly, the US initial jobless claims have historically functioned as an early signal that it could be time to sell, but as we can see in the most recent data, there are no signs of any trouble or change in direction of the downward trend, which could mean continued smooth sailing for shares.'

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Chart 2: Consumer confidence

'Look for another warning sign that it might be time to cash out in the form of the resilience of US consumer confidence, which is a closely followed barometer of consumer attitudes measuring confidence towards business conditions, short-term economic outlook, personal finances and jobs.

'Here we have another tight historical correlation with the S&P 500, suggesting that levels of consumer confidence will act as a powerful selling signal if we should get a significant dip.

'However, US consumer confidence has been soaring, jumping in March to its highest level since December 2000. With Americans only growing more upbeat about present and future conditions, there are no warning signs here for an imminent sell-off.'

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Chart 3: Manufacturing

'Third on our list of market correction watch list indicators is the US ISM Manufacturing PMI. This indicator is based on a survey of private companies that acts as a gauge for the economic health of the manufacturing sector, which is an important driver behind economic growth.

'The ISM PMI looks at major factors like new orders, inventory levels, production, supplier deliveries and the employment environment, making it a useful snapshot of US economic health. Importantly, the US ISM Manufacturing PMI has a history of predicting the direction of the S&P 500 index, as shown below.

'Large market falls have tended to coincide with readings below 50, indicating that the economy is contracting. On that basis, if we take a look at the current picture to know what the future might hold, we can see manufacturing is holding steady.

'In fact, the ISM Manufacturing PMI at 57.2 in March is close to the highest since December 2014 and is consistent with strong economic growth. No signs here that manufacturing weakness is going to weigh on the progression of the equity bull market.'

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Chart 4: Housing starts

'Our next forward indicator to watch for warning signs of an imminent bear market is US housing starts. In other words, this is an indicator measuring the number of privately owned new houses (or housing units) on which construction has started in a given period.

'You might wonder why US house building has such an important impact on global shares sentiment, but it is a barometer for the health of the whole housing market which is a key part of the US economy that has an effect on consumer confidence and the health of the mortgage market.

'In a healthy economic cycle, people are more likely to purchase new homes. Conversely, if they’re feeling nervous about the economy they are less likely to buy a new property and so the construction industry builds fewer houses. In terms of why it matters as a market signal, the chart below shows the relationship between US housing starts and the S&P 500 over the last 20 years.

'Again, the pattern here is very clear – downturns in US housing starts predict bear markets. However, today, with US housing starts beating expectations and climbing to a fourth month high as of February, there are no signs of danger.'

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Chart 5: Economic index

'Our last warning signal for when we could be entering bear market territory is the US Conference Board Leading Economic Index.

'This is put together by a not-for-profit research organisation as a forecast of future economic activity based on ten key variables. It combines several components in order to help signal swings in the business cycle and to smooth out some of the volatility of individual indicators. These variables have historically turned downward before a recession and upward before an expansion.

'As we can see in the chart, shares tend to move in step with this leading economic indicator, making it a relevant warning signal of a possible correction. But taking the latest pulse, we saw in March that the Conference Board’s economic index reached its highest level in over a decade, a sign that the US economy could continue growing in the first half of this year.'

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Conclusion

'Watching a confluence of factors to judge when economic sentiment is likely to lead to a bear market is an important part of navigating the late cycle stage of a bull market. A mixture of indicators across corporate profits, confidence, business investment, manufacturing and housing suggest to us that there’s no immediate concerns that a looming recession could spell the end of the global bull market run.

'It’s certainly reasonable for investors to be concerned about what are reasonably high valuations on a historical basis, but it is worth bearing in mind that historically valuations haven’t been a particularly reliable indicator of an impending bear market.

'Finally, investors considering taking their profits at this point and going to cash should consider one last chart. History teaches us that the performance of shares in the last leg of a bull market tends to be strong.

'This final chart shows all of the major bear markets (meaning a correction of 20% or more) going back about 100 years for the S&P 500 index, to consider if we can learn anything from the past about the characteristics of bear markets, to predict the future.

'One pattern that is incredibly clear about the macro-environment is that bear market corrections are almost always due to economic recessions. But what’s particularly interesting for investors who might be feeling conservative, with share prices having run up so far, the circled table on the far right shows the returns on shares in the last 12 months and the last 24 months before the end of the bull market.

'On average, stock markets returned nearly 40 in the last two years of a bull market. For investors thinking of going to the sidelines now, that is a LOT of upside potential to sacrifice!'

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