Richard Bernstein: 3 Signs to Watch for the Next Bear Market

Richard Bernstein has been very bullish over the last few years and very right. I’m biased towards his research because I was a big fan back during my other life at Merrill Lynch, but even my less biased half still thinks he’s a very good analyst (in other words, that’s my full biased self telling you he’s good).

Anyhow, he has a nice piece of research out that’s providing a very optimistic view of the economy.  In particular, he notes that none of the classic signs leading to a bear market are presently in place.  He’s worth listening to on this one because I specifically remember his constant warnings of a profits recession during the housing bubble.

Here’s his commentary:

“There are three classic signs that have historically strongly suggested that a bear market might be nearing. None of those three signs are evident today in the US. These signs are:

• The Fed tightens too much – historically bull markets didn’t end when the Fed started to tighten. Rather, they ended after the Fed tightened too much. A classic indicator that the Fed has tightened too much is an inverted yield curve (i.e., short-term rates higher than long-term rates). The Fed has indicated that they do not anticipate tightening anytime soon, and an inverted yield curve seems years away.

• Significant overvaluation – Our valuation models continue to suggest that the market is significantly undervalued despite the four-year bull market. More important though is the high level of uncertainty among investors. Uncertainty, according to classic financial theory, indicates undervaluation. Markets tend to be overvalued when investors are certain, and undervalued when investors are uncertain. In fact, this is a financial tautology. Most investors would agree that there is great uncertainty surrounding the US equity market. Therefore, the US market must be undervalued.

• Euphoria/Asset class of choice – It is hard to argue that US equities are the asset class of choice when Wall Street strategists are recommending a historically low equity allocation, pension funds have very low equity allocations relative to history, and US equity mutual funds were, until very recently, experiencing net outflows.

These signs are increasingly evident in the emerging markets and, as usual, investors don’t believe the signals apply. However, these signals do not appear within the US equity market. It is somewhat ironic that investors are enamored with the emerging markets despite that those markets are showing the typical signs of risk, but feel the US market is too risky even though the risk signals might be years away.”

Source: RBA