A rising tide lifts most boats, and a ceding water line, lowers most. http://usmarket.seekingalpha.com/article/25421 John Hussman: Bayes' Rule and Bear Markets Posted on Jan 29th, 2007 Excerpt from fund manager John Hussman's weekly essay on the U.S. market: In the financial markets, investors spend a great deal of effort trying to determine whether stocks are in a bull market or a bear market, whether interest rates are headed higher or lower, and so forth. Unfortunately, these are âhidden variables.â We can't observe them directly, except in hindsight. At best, we can try to figure out the probability of those things that we can't observe, given evidence about things we do observe. We might be interested, for example, in estimating the probability that stocks are about to enter a bear market, given some amount of observable evidence. That seems like a difficult question to pin down, but it's easier if we work backwards. Specifically, can look back historically and ask the reverse question: When stocks were about to enter a bear market, what was the probability of observing conditions similar to the present? Suppose that the unobservable thing, âX,â is whether or not the market will enter a bear market over the next 13 weeks, and the observable evidence is âE.â We can go back historically and count, when X was true (in hindsight), how often we observed E. We can also count, when X was not true (~X), how often we observed E. We can then apply a calculation called âBayes' Rule:â Probability of X, given the Evidence = (Cases where we observe both X and the Evidence) / (All cases where we observe the Evidence)... A few weeks ago, I noted that historically, we've observed relatively few instances when the S&P 500 traded at a 4-year high, at over 18 times record earnings, with advisory bullishness over 53% and with Treasury bills rising above their level of 6 months earlier. Of the many abrupt market declines we've observed since 1960, say, where the market dropped by 10% over a period of several weeks, only about half of those instances were preceded by the above conditions. But the outcomes have been unanimously unfavorable when these conditions have been observed... Bayes' Rule currently puts the likelihood of a 5% or deeper market correction beginning within the next few weeks at near certainty, the probability of a 10% correction starting during the next 13 weeks at about 65%, and the probability of a bear market beginning within the next 6 months at over 75%. There is, of course, no such thing as certainty in the financial markets. Suffice it to say that the probabilities aren't good... Importantly, our investment position does not rely on a market decline. A fully hedged position implies only that, on average, the market has historically underperformed Treasury bill yields (currently about 5% annualized) in conditions similar to the present. History indicates that we should not rule out substantial market losses here, but neither should we ever rule out the possibility of further gains. But as investors who believe that markets tend to experience both advances and declines, we look at market movements in the context of a complete market cycle. The case for the market gaining substantial ground and actually retaining it through the remainder of this market cycle looks very thin, in my view. Read more John Hussman weekly essay excerpts on Seeking Alpha.