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Markets

How to Spot the Next Bear Market

If you see these signs, you may want to pull in your horns.

There's little question we're in a bull market now, with the market up some 88% since its March 2009 low. And Kiplinger's thinks that stocks will continue to rise in 2011 (see our investment outlook -- Where to Invest in 2011). So this is the perfect time to ask: How will we recognize the next bear market? In the spirit of staying a step ahead, we asked a few expert trackers for signs that would indicate an ursine presence on Wall Street.

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Usually, stocks are a barometer for the economy and not the other way round. But some forward-looking indicators can prove prescient. Jim Stack, of InvesTech Research, tracks the Purchasing Managers index, released by the Institute for Supply Management on the first of each month. The survey is a gauge of the earliest stage of the manufacturing cycle. A reading above 50 (it's 56.9 now) signifies that manufacturing is expanding. Recently, new orders have rebounded after falling off last summer. A dip below 50 on the index could signal trouble for the economy, and for stocks.

Sometimes the market itself will tell you it's flagging -- if you know where to look. Headline-making indexes, such as the Dow Jones industrial average and Standard & Poor's 500-stock index, might show strength that camouflages fatigue in the rest of the market. "I'd be concerned if I saw small-cap stocks, emerging-markets stocks and transportation stocks -- which have been on a tear lately -- start to lag blue-chip averages," says Leuthold Group strategist Doug Ramsey, in Minneapolis.

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Similarly, Michael Cintolo, editor of the Cabot Market Letter, looks for signs that market leadership is narrowing. "We look at stocks institutions have to buy, the leading edge of the economy," says Cintolo. Today, that's tech leaders such as Apple and Google, or commodities giants, such as Freeport-McMoRan Copper & Gold. When leaders start to falter, the process can encompass months of small corrections.

One bear-market sign is a cinch to track. "We call it the two-second indicator," says Cintolo. That's all it takes to check the financial news for the number of stocks hitting new lows on the New York Stock Exchange each day. When that number hits 40 and above, the bear may be creeping closer, often while indexes continue to hit new highs.

Nothing attracts a bear like stocks that are too expensive. Leuthold's Ramsey thinks the market will be too pricey when stocks in the S&P 500 sell collectively at about 21 times average earnings per share -- the median for modern-day bull-market peaks.

Leuthold adjusts earnings for ups and downs over rolling five-year periods, so by the firm's calculations, the market is selling at about 18 times earnings now. For the S&P 500, the danger zone would begin just north of 1350 -- up about 10% from where it is now and about double its bear-market low.

Two favorite indicators might not provide clear signals this time. Interest-rate hikes by the Federal Reserve Board often usher in bear markets, as do sentiment surveys that show ebullient investors. But the economic recovery is fragile, and investors -- despite recent gains -- remain wary of stocks. By the time rates rise and bulls rule, the game might already be ending.

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