The Top 5 Warning Flags

05/28/2013 6:30 am EST

Focus: MARKETS

James Stack

President, Stack Financial Management

The bull is still running, but investors should be alert should these five warning flags appear, says Jim Stack of InvesTech Research.

While bull market tops can be unpredictable, there are five key warning flags that we are currently watching that will help identify the risk of a possible bear market ahead.

Rather than following the deficit battles in Washington, investors should focus on both the 30-year T-Bond and the US dollar for a loss of confidence in the Federal Reserve.

No. 1: 30-year T-Bond Yield. If the economy starts to stagnate, even in the face of easy Fed monetary policy, 30-yr T-Bond yields could drop to a new low—which would carry a deflationary message of probable recession.

No. 2: US Dollar Index. The US dollar has been remarkably stable—as Goldilocks might say, "Not too strong and not too weak." However, a major warning flag would occur if the dollar suddenly drops to the lows seen in 2008, putting upward pressure on long-term interest rates.

Key technical indicators, such as breadth and leadership, will also give us insight on underlying market strength (or early weakness)...

No. 3: Advance-Decline Line. When bull markets begin to form a top, investors become more selective and market participation narrows. This is when the Advance-Decline Line, one of the most reliable bear market warning flags, begins to diverge from the major market indexes. So far, the A-D Line has been steadily leading the indexes higher.

No. 4: InvesTech Bellwether Index. The economically sensitive InvesTech Bellwether Index is designed to forewarn investors when they should start battening down the hatches in advance of a significant decline. Prior to the last four bear markets, this Index diverged well in advance of the S&P 500. Currently, no trace of a divergence can be seen.

No. 5: NLC Distribution. The "distribution" component of the Negative Leadership Composite is one of InvesTech's best gauges of bear market risk.

It is a "fail-safe" tool that forces investors to assume a more defensive stance when downside leadership (the number of stocks hitting new yearly lows) starts to accelerate—as it does during every bear market. In the absence of a "distribution" reading below zero, we continue to give this bull market the benefit of the doubt.

The media may be touting the "Sell in May and go away" mantra, but even the seasonally softer summer period realizes gains the majority of years. In fact, during bull markets since 1928, the May-October period was positive 78% of the time. In contrast, whenever the market finished May-October with a significant decline of more than 10%, it's been in the midst of a bear market with other warning flags present.

Today those warning flags are notably absent, and the weight of evidence outlined in this issue suggests the bull market remains intact. However, the current slow-growth economy dictates that we remain exceedingly vigilant for signs of weakness and flexible with our strategy going forward.

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