Users Manual for a Bear Market

   

Bear markets have been nearly as rare as National League victories in baseball’s All-Star game in recent decades, as corporate executives, brokerages and government officials conspired to keep stocks buoyant at all costs.

Yet saying something seldom occurs is not the same as saying it never occurs, and so now investors find themselves in a bear market without the skills necessary to survive.

So let me give you some of my guidelines on bear markets to help smooth your transition.

First, this week’s action has provided no evidence that the market is bottoming.

You can talk all you want about sentiment being too low, and pessimism being too rampant, financial crises setting bottoms and all the other subjective fluff that is thrown around. It’s all speculation and wishful thinking.

The reality: Pessimism alone cannot set a bottom. There have to be enough buyers.

And for now there is no credible evidence that institutions have been acquiring stock at current levels from panicked sellers. Quite the opposite.

Second, evidence suggests that the worst of the bear market lies ahead—not behind.  

In my newsletters, I have talked a lot about a violation of the 12-month moving average as my signal for the start of a bear phase for a stock or index. That occurred at the end of December for the S&P 500 (SPX) and Dow Jones Industrials (INDU), leading to my warning to you that a bear market had definitely begun.

But now we need to focus on the importance of the 200-week average. When that level breaks, there is virtually no hope for a market to recover quickly.

Sorry to be so graphic, but it’s more like a gash across the throat rather than a mere stab wound in the chest. We’ve now had three straight weekly closes below the 200-week average. (See also: “Finding the Stock Market Bottom.”)

As a market falls, volatility intensifies and down days become more extreme. Expect to see single days when the Nasdaq sinks or rises by around 100 points.

Third, a market that falls below its 200-week (4-year) average is usually destined to head to  its 200-month (16-year) average.

I learned this shocking concept from independent institutional analyst Mike Belkin during the last bear market, and it was great guidance.

Lest you think that’s a crazy idea, the Bank Index ($BKX) and S&P Financials SPDR (XLF), which encompasses titans Citigroup (C) and Wachovia (WB), is already well below this level. So are General Motors (GM), Ford (F), insurer American International Group (AIG), International Paper (IP) and Bristol Myers Squibb (BMY). General Electric (GE), Intel (INTC) and Merck (MRK) are close.

Moreover, you should know that the 200-month average was the exact spot where the plummeting Nasdaq Composite finally bounced and recovered in 2002.

The 200-month averages for the big indexes now: 981 for the S&P 500 index; 1,771 for the Nasdaq Composite; 8,360 for the Dow Jones Industrials.

Fourth, the best course in a bear market is to use rallies to close out all long positions in the riskiest groups, including tech, cyclicals, indexes and technology.

It’s a fool’s game to try to hold onto the “best” indexes or “best” stocks in these groups.

You might pick out the one or two that survive, but it’s unlikely. The majority of your funds should be safely in cash, with some risk money devoted to my trading picks and short-selling. (See also: “5 Rules for Bear Market Investing” and “You Still Need Stocks, Just Not The Headaches.”)

Beware of rumors of government intervention; or the widespread belief that trillions of dollars are on the sidelines ready to be invested; or the removal of a single threat, such as higher energy prices. None of these things matters until you get a firm signal that buyers are really coming back to the market with intensity.

Bull markets may rise along a “wall of worry” bear markets fall along a “slope of hope.”

Fifth, long bear markets are usually deep.

The average bear market of the past century has lasted less than a year and generated losses of 30%. But ones that lasted more than 12 months showed an average loss of 42%.

All of these figures are averages with relatively few examples, however, and thus deceiving in their exactitude.

The current bear market was caused by a perfect storm of  trouble: a real estate collapse, credit disaster, oil price mega-spike, recession and inflation.

Will it persist for only an average amount of time and decline by only an average amount?

That’s an open question. Put me down as doubtful. For your scorecard, this bear market has so far generated a loss of 21% and lasted 9 months.  

Sixth, evidence of a bottom can emerge at any time without warning.

Just because there is no current evidence of a rebound doesn’t mean that it won’t crop up in the next few days or weeks. (See also: “Finding the Stock Market Bottom.”)

It’s very unlikely, given historic patterns of buying and selling pressure. But it could.

This means we just have to remain flexible and open to the idea that enough buying can be summoned up by lower prices at some point, even potentially soon, to fill the vacuum created by selling.

Seventh, a reversal higher can be swift and big, and it is usually disbelieved at the start.

Eventually all bear markets end—very often with a roar, and when least expected.

The only statistical measure that I have ever seen work effectively in the past 20 years to signify the end of a major bear phase is a 1-2 punch in which the market experiences one more in a series of 90% downside days and then, with three days, experiences a 90% upside day. Most recently, this is how the 2000-2002 bear market ended, in late March 2003.

When that massive buying occurs, most investor don’t believe the inflection point is really occurring and consider it just one more rally to sell into or short. But in reality, that has been the signature of the end of a bear.

I will be watching for this, and will accept no substitutes. When the time comes to rally out of this bear, gains will surpass 30% in the first six months.

In summary, bear markets are difficult times for our psyches and our wealth. The market gods are devilishly clever in their attempt to encourage you to do the wrong thing.

We are naturally optimistic, and always want to grasp at the possibility that a bear phase is over too soon. But this is a time to sit in cash, not take the bait, short selectively via inverse ETFs, such as ProShares Ultrashort Financials (SKF) and await better opportunities to deploy our funds.

When the time comes, we will make a fortune on the reversal. Until then, keep your capital safe, chill out and just enjoy life.

This article was written by Jon Markman, contributor to InvestorPlace Media. For more actionable insights likes this, visit www.InvestorPlace.com.


Article printed from InvestorPlace Media, http://investorplace.com/2008/07/users-manual-for-bear-markets/.

©2014 InvestorPlace Media, LLC

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