Thursday, August 28, 2008

INVESTORS/TRADERS GUIDE TO BEAR MARKETS

Perhaps one of my best articles yet. Plain no-bs truth about bear markets...enjoy.

Bear Market: A market condition in which the prices of securities are falling, and widespread pessimism causes the negative sentiment to be self-sustaining. As investors anticipate losses in a bear market, selling continues, which then creates further pessimism. Although figures can vary, for many a downturn of 20% or more in multiple broad market indexes, such as the Dow Jones Industrial Average (DJIA) or Standard & Poor's 500 Index (S&P 500), over at least a two-month period, is considered an entry into a bear market. – Investopedia

As long as humans invest and trade and the laws of supply and demand continue on, we will always have bear markets. They are inevitable. Bear markets form when prices exceed the value perceived by investors and traders and public enthusiasm and greed overtake reason and logical thinking, cause stocks to rise to unsustainable, excessive levels. We saw that in 1999-2000 and we also saw that (to a lesser degree) last year when many companies became overvalued. To understand bear markets, investors must first look at the history of them.

The Colorful History of Bear Markets

Those who cannot learn from history are doomed to repeat it. – George Santayana

*All figures are for the DJIA, except for 2000 (NASDAQ)

This is the 108 year history of bear markets in the U.S. As you can see there’s a bear market, on average, about every 3-5 years. The declines ranged from 15% to 90%. Also note that the 15% is currently for the one we’re in now and although the standard definition of a bear market is “-20% or more”, the DJIA did hit 20% at the July low. Given that ever bear market has exceeded 15%, it is highly, highly likely that the current decline in this bear market will continue. The average duration for a bear market has been around 17-18 months with a wide range of as short as less than 2 months and as long as 56 months.

Ever heard of the phrase, “Stock markets go up a third of the time, down a third of the time, and sideways a third of the time?” That may not be far from the truth. Since 1900 until now, we’ve been in a bear market for 383 months, or 32 years. This means that we’ve been in a bear market for 30% of the time. Pretty close to a third, I’d say.

Secular Bear Markets

History is a guide to navigation in perilous times. History is who we are and why we are the way we are. – David McCullough

Secular bear markets are long-term, typically lasting for 4-20 years. As long as each secondary bull market high and secondary bear market low is lower than the previous ones, then we’re in a secular bear market. The long-downward swings are called primary trends, and the bull markets would be considered counter-trend rallies. We are currently 9 years into a secular bear market.

Historically since 1900, we’ve been in 5 secular bear markets:

  • 1901-1920 (20 years)
  • 1929-1932 (4 years)
  • 1937-1941 (5 years)
  • 1966-1981 (16 years)
  • 2000-Present (9 years)

The Importance of Volume (4 phases)

“Note that bear market cycles begin on reduced volume. As the major downward phase develops, volume increases and this phase ends in a selling climax on heavy volume. The ensuing rally is accompanied by declining volume, which dwindles until the rally loses momentum completely, and the major trend is resumed in a new bear cycle…Bear market rallies start out of active climaxes.” – H.M. Gartley

What he’s say is: In the early stage of a decline, the volume is pretty light. The professionals and the “smart” money are selling, while the public are still asleep. In the second phase, the big money is still selling, and the public starts to unload, but not entirely. The heavy volume that’s present at the third stage is due to a selling climax as now the mass of retail investors are dumping everything that they own creating heavy volume. In the fourth stage, there’s a reaction due to short covering and professional buying, however, the retail investors are still not finished selling, even at the beginning of a rally. Price tends to follow volume, and volume confirms price action.


Secondary Reactions/Counter-trend Moves

“Bear markets seem to be divided into three phases: the first being the abandonment of hopes upon which the uprush of the preceding bull market was predicated; the second being the reflection of the decreased earning power and reduction of dividends; and the third representing distress liquidation of securities which must be sold to meet living expenses. Each of these phases seems to be divided by a secondary reaction which is often erroneously assumed to be the beginning of a bull market.” – Robert Rhea, author of The Dow Theory (1932)

Every bear market has always been made up of 2 or more major downward swings, or primary legs down, and at least 1 secondary reaction between 2 legs. The purpose of the secondary reaction is to correct oversold levels and to reduce speculative activity brought on my new investors. The problem with identifying when a secondary reaction begins is that a primary leg may or may not end on high volume, therefore as with trying to find a bear market bottom, identifying the start of a rally may be difficult. However, when capitulatory volume is present and the market has made a near vertical parabolic move down, then it may signal that the primary leg has ended.

The secondary reactions in most cases take lesser time and may swing with more volatility than the primary leg itself. We are currently in a secondary reaction due to the fact that the price is divergent with volume. As volume declines further, we should see a reversal. Afterwards, we should again see heavy volume resume on the down days.

Another divergent characteristic is the divergence between indices. For example, currently the Russell 2000 and the NASDAQ are performing fairly well, but the DJIA and SPX are getting crushed. Typically, one of the indices reaches a high, but the others are unable to do so. This characterizes “phantom” weakness in the markets that may not be readily visible in the presence of a rally.

A secondary reaction ends as bullish sentiment starts to wane. First, people don’t believe that the rally is ending, but slowly and surely, more and more people start to believe. Once the majority changes their opinions, the next primary downward swing is underway.

The rallies may end at the 50% retracement level, as most people like to believe, however, that’s not true in most cases. These reactions can be as little as 10% or 99.9%, and has history has shown me is that only 7% of reactions end at the 40-55% level. 27% retrace 55-70%, 8% retrace 70-85%, and 14% of secondary reactions retrace past the 85% level. There seems to be this herd mentality that if a secondary reaction goes past the 50% level, these “experts” start to claim a new bull market…


The “V” Bottom These People on TV Are Talking About…

If you're not confused, you're not paying attention. –Tom Peters

When you argue with reality, you lose - but only 100% of the time. –Byron Katie

There is no data on bear markets that formed a “V” bottom that have surpassed a16-17 month bear market duration. For example, the 1929 bear market took 26 years to recover. Since 2000, we have not recovered in the NASDAQ, but we have recovered in the DJIA, only to fall back to the pre-2000 bear market level anyway.

You want to avoid “experts” who just love to forecast where the market is heading. Here’s why:

*Figures are for the DJIA

This is a compilation of Barron’s and BusinessWeek strategists’ forecasts. Notice how they’ve collectively been wrong the entire way down (3 years)? Bottoms are truly verified in hindsight, but until then, ignore the pundits who preach about finding the bottom and believe that we’re still in a bear market. Instead look at a variety of economic, fundamental and technical hard data to help you get close to one.

The End of Bull & Bear Markets

Great is the art of beginning, but greater is the art of ending. – Lazurus Long

Here’s how to tell if a bear market is ending

  • Instead of the price-volume divergence we see in the current rallies, volume actually picks up on rallies and dry up on pullbacks
  • Zero confidence, investor sentiment is at a serious low
  • No good news on the front pages, negative news permeates the media
  • Lack of credit, lack of buying power
  • Real Estate still remains down, commercial properties take a big hit, vacancies high
  • Slight improvements from a feeling of total hopelessness for the market
  • Investors take money out of the market, because they actually need it
  • And many other indicators

Strategies in a Bear Market

I'm not afraid of storms, for I'm learning how to sail my ship. – Louisa May Alcott

  • Learn how to short, and short well
  • Buy stocks that hit capitulation and play the rally
  • If you have to go long, there’s always a market/security that’s going up somewhere in the world
  • Stay in cash, get out of the market, and go on vacation

3 comments:

LT said...

Hi John... really good stuff here!

Glad I found you and thoroughly enjoyed reading your thoughts on bear markets.

Keep up the good work...

Chuck

John C. Lee said...

Thanks, Chuck. Glad you liked it.

Anonymous said...

Hi John,

This is one of the most informative post for the bear market behavior I'd read so far.

Thank you.

ZZTOP