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The popular notion that a bear market is defined as a 20 per cent decline from the high seems completely bizarre. Such a definition has no informational content whatsoever. Over the past 12 post-war US stock market cycles, the median decline from peak to trough of the S&P 500 index has been 27.5 per cent, so investors would have incurred over two-thirds of their total loss before someone pointed out they were in a bear market. They would be too late to sell and too early to buy. Surely we can do better than that, and get investors out before they have lost a fifth of their money.

The more commonsense definition of a bear market is it is characterised by a fundamental change in direction from up to down. In practical terms, we should look for the following touchstones:

•A progression of lows below previous lows, and of highs below previous highs

•A fall below a long-term uptrend on a semi-log chart – which picks up changes in trend earlier than arithmetic charts – generally accompanied by

•A fall below the neckline of a major top formation

Quite often there is then a sharp downward move, but this is frequently succeeded by a strong rebound from a deeply oversold position. All of these features are present in the S&P 500, but equally apply to the FTSE World index.

The bear market is only confirmed if the rally fails to close significantly above the neckline. Typically chartists would look for a safety margin of 2-2.5 per cent before they would consider the downtrend has been invalidated. In the case of the S&P 500, this would imply a rally above 1445, but the index failed to sustain a rally above the 1410 neckline.

Note that the index is still above its 25-year uptrend at 1300. Failure to find support on this would be serious. In the case of FTSE100, this would imply a move above 6220-6250, something it has yet to do.

There is a natural rhythm to both bull and bear markets. It is easy to believe the typically powerful bear market rallies constitute the start of the new bull, but post-war bear markets have lasted between 1.5 and 36.5 months, with a median of 16.2 months. If we take the peak of the S&P 500 as occurring on 10 September 2007, only eight months have elapsed and we may have a further eight months to go – if we are lucky.

There is clear evidence of economic slowdown in the West, but until recently, investors have been looking across the valley hoping to discern the sunny uplands beyond. They may be disappointed. The credit crisis has spread into the real economy, and even though there has been some recapitalising of the banking sector, senior loan officers remain cautious. Loans are scarce and expensive, but the US Federal Reserve is increasingly concerned about inflation, and the next rate move may even be up not down. The growth of the US economy has been powered by a steady fall in household savings ratio, accompanied by a rise in mortgage equity withdrawal from rising house prices. With the US savings ratio close to zero, house prices still falling and borrowing costs high it is hard to see a consumer-led recovery.

The economy was saved from recession in Q1 by involuntary inventory build, but this is now unwinding, transferring recession risk to Q2-Q3. The situation in the UK, Italy, Spain and Ireland is no better. Growth is slowing but inflation remains sticky despite a strong euro. Neither the Bank of England nor the ECB is likely to cut rates soon.

There is a psychological cycle to a bear market. In its early stages investors buy on dips because this has proved rewarding during the previous bull market, and is often similarly rewarded in sharp bear market rallies. As markets fail to make headway against the resistance of a previous top formation, however, bullish sentiment deteriorates, and optimism is further dampened by weakening economic data, cautious guidance by companies and the belated downgrades by analysts. Sell-side analysts are congenital optimists, and are particularly bad at forecasting earnings during a recession year. There could be significant downgrades to come.

Capitulation occurs when the last bull has been forced to liquidate his positions – typically because he has been ordered to do so by his trustees at the bottom of the market. This tends to mark the final phase of the downturn, when sentiment is so bad the buyers have completely deserted the market, and forced sellers therefore cause disproportionate price falls – as happened in 1974 and 2002. The chart of the market begins to resemble an inverted parabola, with price falls accelerating in percentage terms and volume spiking as the bear market reaches its climax.

The bear market ends when the sellers are exhausted and the index begins to break above its downtrend on an arithmetic chart. This is accompanied by appalling economic and/or corporate news that fails to drive down the index further.

The UK market has in the past bottomed on news of bankruptcies of leading companies such as Rolls-Royce. There were clear signs of a selling climax at the time of the Bear Stearns crisis and the shock losses at UBS, and these low points have not been breached despite continuing bad news. Indeed, the stream of losses and capital raising announcements from the financial sector has been greeted as indicating the crisis has run its course.

There is evidence investors are unprepared for a weak and protracted economic recovery which will put pressure on the corporate sector. The supply/demand balance for equities is also deteriorating. Over the last three years, US corporations bought back a net $900bn (£460bn) of their own equity, thanks to cheap financing. This year, the recapitalisation of the global financial sector is sucking cash out of investors’ pockets. By mid-May, European financials alone had announced plans to raise $79bn of new capital.

Can we really expect PERs to rise in the face of a worsening profit outlook and a growing supply of paper? Only if there is a complete earnings collapse, but investors discount this and focus on hopes for recovery. Given also the extent of the credit crisis, the pervasiveness of counterparty risk, which is still underestimated by investors and the continuing decline in the global economic leading indicators, it would be surprising if the bear market has ended after a mere eight months.

The May rebound should be regarded as being no more than a bear market rally. What would change this? A significant fall in the oil price, since this would immediately benefit the US consumer.

Richard Cragg is global strategist and Smith & Williamson