Investing

Worrying that the market is headed for a downturn? Check these 5 indicators

"Bears can take a big bite out of your portfolio. And they're harder to predict."

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With stock indexes recently hitting all-time highs, no one would blame investors for taking a moment to rejoice. But markets are ever forward-looking, and experienced investors know that it's only a matter of time before the next major pullback.

If you're invested for the long term, you needn't sweat the prospect that the market may fall by 5% or 10%, says Sam Stovall, chief investment strategist at CFRA. "Since World War II, there have been 96 declines of 5% or more and 83 of them have been declines of 20% or less," he says. "That's important to note because, on average, it has only taken the market 4 months to break even following such declines."

It's hard to predict whether a market slide will stay in the shallow end or go deep into bear market territory — defined as a decline of 20% or more from recent highs. "Bears can take a big bite out of your portfolio," says Stovall. "And they're harder to predict."

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If you're not prepared for losses, the shock of seeing all that red could prompt you to make rash investment decisions that could hurt your long-term returns. And because markets often reflect investor prognostications about the direction of the economy, a bear market often means a recession is on the way — it typically hits six to nine months after the market top.

To stay prepared, keep an eye on the following five indicators, which may hint at a market top before things begin to slide. Think of them as gauges on your car dashboard. One of them lighting up isn't reason to panic, but if all five are flashing, it could be time to re-evaluate risk in your portfolio.

The yield curve

What is it?

The difference between the yields on two bonds of varying maturities — typically one short-term and one long-term. The most commonly tracked are the 2-year Treasury vs. the 10-year Treasury and the 3-month Treasury vs. the 10-year Treasury.

Why is it important?

In a healthy economy, bonds with longer maturities pay a higher rate of interest (known as a yield) than those with shorter maturities, in order to compensate investors for the extra risk they take by holding onto the bonds for longer. While short-term bond rates are driven by the Federal Reserve, longer-term bond yields reflect investor expectations about the economy. If investors think the economy is headed south, they tend to buy up long-term Treasurys, hoping to lock in a higher interest rate in a very safe investment (U.S. Treasurys have never defaulted).

Because bond prices and yields move in opposite directions, a decline in long-term bond yields is seen as a harbinger of a weak economy.

It's especially concerning when long-term rates dip below short-term rates, known as a yield curve inversion. "If the yield curve inverts, then the market usually goes into a bear shortly thereafter, because it implies a recession is at hand," says Stovall. "It becomes unprofitable for financial institutions to lend, so loan activity essentially shuts down."

Should I be concerned?

No. At the moment, the 1.19% 10-year Treasury yield comfortably exceeds the yield on 2-year (0.17%) and 3-month (0.05%) Treasurys.

Consumer confidence

What is it?

The Conference Board updates its consumer confidence index monthly, reflecting consumers' attitudes on economic topics such as business conditions, job availability, and their ability to save.

Why is it important?

Consumer spending is important to the U.S. economy. Like, really important: At last glance, it made up 69% of U.S. gross domestic product. In other words, if consumers think the economy is headed in the wrong direction, it probably is.

Should I be concerned?

No. The index has steadily risen as the economy has come out of the pandemic, and it's at its highest level since February 2020. Don't panic unless you begin to see steady year-over-year declines.

Housing starts

What is it?

The Census Bureau and Department of Housing and Urban Development release a monthly report on new residential construction, which includes housing starts — the number of privately owned homes that began construction that month.

Why is it important?

"A house is typically someone's most valuable asset," says Jeff Mills, chief investment officer at Bryn Mawr Trust. Basically, if someone is concerned about the direction of the economy, they're probably not breaking ground on a brand-new house.

As a result, "when you see housing falter, it's usually an early sign that something is amiss," Mills says. With the exception of the Covid-fueled recession of 2020, every recession since 1960 has been preceded by a double-digit year-over-year decline in housing starts, according to historical data compiled by Stovall.

Should I be concerned?

No. Housing starts for June 2021 came in 29% above the June 2020 rate.

Time since the last decline

What is it?

Like a sign in a warehouse indicating the number of days without an accident, this lets you know how long it's been since the last substantial slide in stock prices.

Why is it important?

The stock market moves in cycles, which means that market history repeats itself over and over. The longer the market goes without taking a breather, the more investors should be begin to wonder when the next pullback is coming, says Stovall. "In the words of [singer-songwriter] Brook Benton, it's just a matter of time."

Should I be concerned?

Probably. The market's last decline of 5% or more was a 9.6% slide that began on September 2, 2020, and got back to break-even on November 13. The 265 days since the last such decline is two-and-a-half times longer than the average time between skids. As previously mentioned, there have been 96 pullbacks of 5% or more since World War II. If a downturn happened today, it would be the 11th-longest wait between declines in that period.

200-day moving average

What is it?

The 200-day moving average is a technical indicator that seeks to measure an investment based on its movements, rather than its fundamentals. A simple moving average is calculated by adding up a stock or index's closing price over a given number of days — 200 is the standard "long-term" average — and dividing it by the number of days within that period. It's meant to give you a simplified idea of how an investment is trending.

Why is it important?

If a market index is trading above its moving average, it's generally a signal that things are on an uptrend. But if it's way out ahead of the overall market, it could be a sign that investors are overvaluing stocks — and that they could pull back sharply upon receiving bad news, says Stovall. "You don't want to get too far out in advance, or you could end up like Wile E. Coyote when he realizes he's overrun the cliff."

More concerning is the scary-sounding "death cross," when a short-term moving average, such as the 50-day moving average, falls below the 200-day average. Technicians say that's an early warning sign of a prolonged downturn for stocks. (You can try it yourself by superimposing moving averages on a stock chart on your brokerage's website or on free investing sites such as Yahoo Finance.)

Should I be concerned?

Maybe a little. There's no death cross in sight, but the S&P 500 is way above its 200-day average. Over the past 25 years, it's typically traded 3% above its moving average, according to Stovall. Currently, it's 11.7% above its 200-day moving average.