A Striking Collection of Duck-Like Features

"When I see a bird that walks like a duck and swims like a duck and quacks like a duck, I call that bird a duck."
– James Whitcomb Riley

One of the pitfalls of identifying market conditions using labels like “bull market” and “bear market” is that the accuracy of those labels can only be verified in hindsight. Early technical analysts like Charles Dow, Robert Rhea, and William Peter Hamilton tried to address that uncertainty by requiring various “confirmations” before applying those labels. For example, a new bull market isn’t “confirmed” in Dow Theory until both industrial stocks and transportation stocks experience an initial advance from market lows, followed by a moderate pullback, followed by both indices breaking above the highs of that initial advance.

Uniformity across different types of stocks or assets is essential, because it signals a willingness of investors to embrace market risk. The strongest investment opportunities we identify have two essential features: 1) a material retreat in valuations, followed by 2) an identifiable shift to uniformly favorable market action across multiple sectors. It’s not the label of “bull market” or “bear market,” but those observable features that actually matter. The danger comes when investors say things like “this is a bull market” as if the label itself is informative about the future, ignoring changes in valuation and market internals, and forgetting that the most recent high might also have been the final high.

Likewise, the proper way to use the word “confirmation” is in the sense of “additional evidence.” For example, if at some point our Recession Warning Composite becomes active (and it has not yet done so here), we’ll look for subsequent “confirmation” of recession risk in slightly lagging events like a decline in aggregate hours worked from their level of 3 months earlier, a slowing in payroll growth to less than 1% year-over-year (or 0.5% over a 6-month period), and a decline in consumer confidence of 20 points or more from its 12-month average.

In contrast, the word “confirmation” becomes dangerous when investors use it the same way one would use the word “verified.” When we are talking about the future, the actual outcome is not – and cannot be – known with certainty.

Future-looking labels versus current, observable conditions

Are stocks in a bull market? Are stocks in a bear market? The answer isn’t actually observable in real-time. As I’ve noted for decades, bull markets and bear markets exist only in hindsight. When will the bull market end? It might have ended Friday. I kind of think it did. But that question is irrelevant to our investment outlook, because our outlook is a reflection of current, observable evidence.

We choose our actions based on the conditions we observe, and the range of outcomes that have historically followed. No future-looking labels are necessary. We also pay special attention to features that tend to emerge – usually as a collection – at the most extreme points of opportunity or risk.

The goal isn’t so much to forecast future conditions but instead to identify present ones: to gather observable evidence, to insist on knowing how that evidence has been associated with actual subsequent outcomes, and to align our investment stance with the “distribution” of likely opportunities or risks, understanding that the outcome in this particular instance is unknowable.