A New Bull in a China Shop
On the definition of a new bull (or bear) market.
Reading market reports in the press and elsewhere these days can get to your head. There is a notable rush of excitement in wanting to announce the birth of the new bull market in China. The proclamation rests on a simple calculation: since the end of August China’s equity prices – here represented by the Shanghai SE – have rebounded more than 20%:
A step back. For some reason, it has become “common knowledge” – of the kind that could hurt you a lot – that when prices move by more than 20% either up or down the underlying index (or any other listed security) has entered a bull or bear phase, respectively. This analytical concoction is rather strange if you stop and think about it. It basically says that if a market is up (down) by 20% or more, it will have a better chance of sustaining future gains (losses). Newspapers almost never fail to pick on it, consciously increasing the level of credulity in such hocus-pocus.
There are two issues I can see with this “methodology” to define the state of a market.
The first should be apparent in the above graph. Aside from the obvious post mortem nature of the analysis – that is, you need to see where things have gone to be able to say something about it – one could question the theoretical rigor of the process by asking why not pick another spot in time to make the calculation. Like the end of September:
And while we’re at it, can someone perhaps explain what happened to the previous bull “signal” in July?
The last graph leads straight to my other objection: rallies of 20% or more have also taken place in the midst of the worst market routs in history and vice versa for market dips. Two quick example will suffice. The next graph shows what happened to the S&P 500 in the years 1929-1933:
More recently, in 2000-2003, the same index appeared to be in “bull” mode several times while on its way to losing almost 50% of its value:
The definition of anything in economics and finance is a tricky business but in these cases – financial markets, that is – it is perhaps best to err on the cautious side. And while we all are tempted to jump to conclusions or to be the first to make an announcement, we should strive to abstain from giving the wrong impression when we have the power of influencing the less informed.
Bull or bear markets cannot be solely defined by changes in prices, certainly not when they are in the process of evolving. True, we do have evidence that momentum can exhibit some persistence. But unless one strictly applies an investment process based on it, more substantive analysis and perhaps attention to valuation parameters is recommended before following the crowds of the recent past.
Photo and graphs sources: http://chrisdunnillustration.blogspot.ch/2011_05_01_archive.html; Bloomberg.