Bear markets aren't fun. Investors hate to see their portfolio values sink.
The good news is that major market downturns are only temporary. When will the bear market bottom out? There's no way to know for sure. But here are three key things to watch.
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1. S&P 500 Shiller CAPE
One indicator actually has never been wrong in predicting bear markets. It's the S&P 500 Shiller CAPE ratio. CAPE stands for cyclically adjusted price-to-earnings.
Yale University professor Robert Schiller made this metric famous. The S&P 500 Shiller CAPE ratio is calculated by dividing the average share price of the S&P 500 by the inflation-adjusted earnings per share over a 10-year period.
Every time the CAPE ratio for the S&P 500 has maintained a level above 30, a bear market has ensued. These notably include the bear markets that began in 1929 (which preceded the Great Depression), 2001 (with the dot-com bubble bursting), and this year.
S&P 500 Shiller CAPE Ratio data by YCharts
Note, however, that while the indicator has never been wrong, it hasn't predicted every bear market. As a case in point, the S&P 500 Shiller CAPE ratio was well below 30 before the bear market associated with the Great Recession of 2007 through 2009.
Can the Shiller CAPE also signal bear market bottoms? Sometimes. After the CAPE fell below 22 in late 2002, the S&P 500 soon rebounded. It was a similar story with the short bear coronavirus-fueled bear market of 2020. On the other hand, the CAPE ratio plunged to around 13 before the market bottomed out in 2009.
2. VIX
The Chicago Board Options Exchange Volatility Index, or VIX, measures expected stock volatility using the prices of S&P 500 call and put options. The VIX is sometimes referred to as the "fear gauge" since volatility tends to spike when investors are afraid and fall when investors are optimistic.
When the VIX rises above 30, it can be a predictor that stock prices will soon fall. For example, the volatility index topped this threshold in mid-2008 -- and the S&P 500 crashed soon afterward. The VIX jumped above 30 in early February 2020. A few weeks later, the stock market plunged.
This index can also sometimes signal a bear market bottom. Some investors view a VIX of below 20 as an indication that investors aren't afraid. But this isn't always a great predictor that stock prices are poised to rebound. For example, the VIX was still above 40 when the S&P 500 bottomed out in early 2009 and topped 50 when the market reached its nadir in 2020.
3. Sector rotation
Sector rotation refers to investors moving their money from one sector to another. This pattern is often a pretty good indicator that a bear market is coming. As a case in point, growth stocks began to tumble while value stocks held up well before the current bear market began.
When you see money returning to growth stocks and away from more stable stocks, it could mean that the bear market has bottomed. Granted, this can be a lagging indicator to some extent. The rotation between sectors might not be apparent until after a stock market rebound has begun.
Another idea
The S&P 500 Shiller CAPE ratio, VIX, and sector rotation can provide clues that the bear market has bottomed out. However, as we've seen, these approaches aren't foolproof by any stretch of the imagination.
Here's another (and, in my view, better) idea to consider. Instead of trying to identify when the stock market reaches its bottom, just continue to buy high-quality stocks at attractive valuations on a regular basis throughout the bear market. While bear markets aren't fun, the long-term returns they can help you realize can be exciting.
