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Greetings, fellow Pro-fundity team members -
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D. This Week's Guidepost
"Market Risk #3, Bear Market Blues:"
- If you’ve seen your portfolio value plummet, as the bear roars, this is surely a time for the blues. There was a movie years ago with a scene where anyone entering this particular bar had to sing the blues before they could leave. Sound familiar? As we consider market risk, the lessons we can learn from a bear market are multitude. Let’s consider in this guidepost what a bear market really is, how it has shown its ugly head in recent years, and how we might take advantage of the lessons learned with rolling stocks.
- What are Bear markets?
- The following table shows bear markets over the last 24 years. A bear market has been loosely defined as a decline in a major stock index of 20% or more from its latest intra-day high. We have used the Dow Jones industrial average as the key index in this table, except for the last row. Notice under the “Decline” column, two of the Dow numbers do not meet the 20% decline criteria. The first, -10.9%, which began in 1994, was more of a sideways consolidation for just over a year. We included it to help understand the timing between bears. The second, most recent data of -17.2%, is for the Dow. While this does not qualify as a bear market by our definition, the bottom row shows how the Nasdaq reacted. It began its sell-off a couple of months later, but fell over 40%; a clear signal for the bear.
- Looking at the table we find that no two bear markets are exactly alike. During the past 24 years;
- They occur 18 to 77 months apart.
- They last from under two months to over seventeen.
- They decline from the 20% definition to over 40%.
- Subsequent rallies always overshadow the declines, with the rally five times the decline.
- The following chart makes these same points graphically. Notice that the bears seem to occur about every four years, with the notable exception of the latest example. Many questions accompany a bear market. When will it bottom? How far down will it go? Why did the current bear arrive two years early? Which stocks or sectors will emerge as leaders for the next rally?
- The following table shows bear markets over the last 24 years. A bear market has been loosely defined as a decline in a major stock index of 20% or more from its latest intra-day high. We have used the Dow Jones industrial average as the key index in this table, except for the last row. Notice under the “Decline” column, two of the Dow numbers do not meet the 20% decline criteria. The first, -10.9%, which began in 1994, was more of a sideways consolidation for just over a year. We included it to help understand the timing between bears. The second, most recent data of -17.2%, is for the Dow. While this does not qualify as a bear market by our definition, the bottom row shows how the Nasdaq reacted. It began its sell-off a couple of months later, but fell over 40%; a clear signal for the bear.
- What causes Bear markets?
- A true bear market does much more than simply signal a correction in the market. Within each economic cycle, there will be many ups and downs, corrections and short-term rallies, V-bottoms and tops with accompanying volume surges. We depend upon these for our rolling stock strategies. But a bear, well, it shakes the psychology of the market dramatically. During a bear decline, many buyers wait in the wings ready to pounce on bargains as prices fall. This creates volume surges on and off as the decline progresses. By the time the bear nears its bottom, the big-money players have tired of repeated failures on the way down. The result finds the bottom of the bear without a dramatic climax. This process shakes out the market in a quest for market efficiency. Remember, the market is constantly in the process of becoming efficient. That is, the value and price of company shares are continually moving closer. It is the function of a bear market to aid this process. A bear market is a natural phenomena that is part of the market in which we trade. It is not some sinister conspiracy to relieve us of all our money. It just seems that way.
- How can we profit from the Bear?
- Our goal is to reduce risk through sound trading management strategies. Since we cannot control when the bear occurs or how much damage it will do, it is essential that we tie things down so that we can sleep when the wind blows. A bear market can be a time of reflection and introspection. What lessons can we learn from the failure or success of previous trading strategies. A key for success in the market is that we never stop learning. A great time for doing this is while the market is in the dumpers.
- We can carefully search for those stocks that have not suffered in the recent decline. These are candidates for our research and consideration during the coming bull market. Strong stocks will form healthy bases and become new leaders as the market turns. We can also study the big losers to find what red flags were sent up. This is preventive medicine for future “flu’s,” and “viruses.”
- This is also a great time to exercise our Paper trading skills. It is not necessary to keep trading during a market slump. Three out of every four stocks will always follow the market, so it is difficult to make money in a bear market. We will get false rallies and breakouts that fail quickly. For rolling stocks it is even more important that we identify entry and exit rules that we follow religiously. See section 3.3 in our book on Timing & Tips.
- The single most important thing we can do to protect our positions in the market is to keep emotions from ruling our actions. Sounds simple enough. Yet, it is the most difficult as well as the most damaging. We all feel great when stocks are ramping higher. But when the market turns down our emotions can make us do silly things. That silliness can cause us to make bad decisions resulting in bigger losses.
- We outline a set of stop-loss strategies in our book. If we adhere to these rules, our losses will be minimized, and we will live to trade again. The choice of only stocks with sound fundamentals is more important in bear markets than ever. It is the best quality stocks that will emerge from the market down-turn, that will turn up from the roll, and that will breakout to pay for the small losses our stop-loss created.
- But, here is an oft-repeated scenario, what these three emotions can do to us:
- Complacency: With the bull market in full swing, anything we buy seems to work. Stocks that aren’t that strong might dip below our stop-loss trigger, but we decide to hang on, to not sell. Since 70% of all stocks will follow the market, the stock does rise and we pat ourselves on the back, satisfied that we are smart traders.
- Denial: The market turns down without warning. Our stocks fall below our buy price, then below our stop-loss. Confidence reigns as we deny the market signals. We hold on, refusing to honor our exit strategies, certain it is just a temporary pullback. But our stock sinks 15%, 25%, then 35%. By now, we are acting on pure emotion. We hope the stock returns to our buy price to at least avoid a loss. Next, we deny the loss by declaring ourselves a long-term holder.
- Despair: The final emotion is one of despair with the bear roaring, indexes down 20%, 30% or more, and leading stocks down 40% to 70% from their highs. Our losses have increased until we sell out in despair. We forget about stocks and the market indefinitely, instead of learning from our mistakes, giving up at the worst possible time. The market is down, but it always comes back. New sectors of stocks are emerging with new leaders ready to move ahead strongly.
- Remember, the market always provides new opportunities. If we miss then, we have indeed failed. We will discuss more important Bear Market tips in coming guideposts. Stay tuned.
It is our intent to help our subscribers understand market strategies well enough to make informed decisions and understand the risks.
TC-2000 tutorials are available on the home page.
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