It is an underlying principle of all rivers: jump in and no matter how hard you fight, the current will sap your strength and take you along with it. Conversely, if you swim with the current, it will carry you along with little effort. This is analogous to trading in sync with the market’s cycle and bias.
Whether the market is bullish or bearish, the function is the same: to bring buyer and seller together. Bull and bear markets are just different ends of the same stick. The key to consistent success is recognizing which end of the stick the market is holding.
Market cycles are long, extending for many months and even years. In some respects, all bull markets act the same and all bear markets are marked with identical characteristics. The stock market is always in one of two states of prolongation. In other words, the larger market is either bullish or bearish. Each market cycle must be treated differently. In most cases, a bull market lends itself to holding positions for long periods, while a bearish market is a trading market. Keep in mind, however, that these states are a backdrop to the intermediate-term action and are not tradable themselves.
One of the best tools for determining the market’s cycle is a monthly chart with an 18-period simple moving average (see “The big picture”).
WHEN CYCLES SHIFT
The confirmed reversal point of the larger market always creates a new cycle. It is best to identify the point where that cycle changes. However, that is not always possible because cycles are measured in months, not days or hours.
First, consider the conclusion of a bull cycle. A bull market’s resolution is not always the result of some cataclysmic occurrence, a concept promulgated by mass media coverage. The factors that lead to a bear market are excessive speculating and unrestrained leverage. Ultimately, this becomes apparent to even the most unsophisticated market participant. When it does, the bull dies.
Phrases such as “things are different now” or “if you would have put $10,000 in this market at the beginning and never sold, you’d be a multi-millionaire today” are common during the last stages of a bull market. Of course, how long that stage will last varies. Bull cycles are also marked by themes. Consider the tech bubble, the nifty fifty bubble, the conglomerate boom, the Internet bubble and, of course, the housing bubble. Such themes are a case of herd driven by greed. Traders must see these phenomena for what they are and not get caught up in the proclamations.
During the latter stages of a bull market, the public will view the start of the upcoming decline as a buying opportunity. The profits they achieved during the bull run will reinforce this belief. In the meantime, as prices continue to creep ever lower, the experienced traders and institutions sell into every rally.
The end of bull markets are periods of erratic volume and extreme vacillation. These conditions are signs to be cautious. Be wary any time prices act irrationally and indicators such as oscillators won’t behave in an orderly and conventional manner. A safe market is a fairly even balance of offsetting trades. An erratic market is a warning sign it is about to implode.
Starting with the year 1900, the length of the average bull cycle has been 40 months and three weeks, or about three and a half years long. This is probably close enough for market timing and hand grenades. During a bull market, approximately 90% of all stocks follow the 100-day moving average higher.
THE BEAR CYCLE
Bear markets tend to sneak up like a thief in the night and when they do, they take no prisoners. Historically, bear markets have usually wiped out half to 90% of the bull markets that preceded them. Furthermore, they managed to accomplish that in about 28% of the length of time the bull took to make those gains.
One important note for bear markets is cash is king. If possible, carry little or no debt into a bear market. Ready access to cash is critical, both for the vicissitudes of life and the opportunity of speculation.
Each period of a bear market, in its turn, is made up of countless tradable moves, both long and short. A working knowledge of these market cycles is a strong aid to glean how a bear market behaves. To understand them, it is important to remember that bear cycles don’t change from black to white and back again. They evolve in shades of gray. The real skill of evaluating the market is to be able to interpret these gray phases as they develop and to adjust before it becomes clear to the general public.
In the first period of a bear cycle, many individual stocks may still make new highs. However, a disturbing number of ordinary stocks are starting to break trend and make significant lows. Frequently, you will find that any time the number of buyers starts to fall below a critical level, institutions will always instigate buying in an effort to support the market. They are trying to swim upstream as the long-term cumulative daily advance/decline ratio ignores their efforts and turns negative. Mergers and real estate projects are often canceled. It becomes apparent that things are not working out the way everyone expected.
As public fear starts to grow, the influx of new money dries up. When it does, the decline begins in earnest. Although the market will occasionally go into a free fall, the general disbelief of the public will normally resurrect it, at least temporarily. Those who buy these dips begin to look like geniuses. This is a period of erratic volume and high volatility represented by a narrow leadership.
In the second period, the bear market now develops a theme and the 52-week lows begin to outnumber the 52-week highs. This second phase is usually the longest of the bear cycle. Usually, after a severe decline, the market once again rallies, but it is not broad based. Meanwhile, the inflows of the mutual funds start to decrease and the market turns choppy. Market makers push stocks as high as they can and then short them when the public thinks it sees the start of a new bull market. Buying the dips is not working anymore. It is time to sell into the rallies.
The third period often contains one or more manic sell-offs, which produce extremely high volume. Yesterday’s gurus become persona non grata. This is a very dangerous place for anyone to play. The national economy is often called into question and even the bears aren’t safe as even the financial stability of the brokerage houses comes into question. Breakaway gaps in the indexes are common and daily price action is extreme. The old fundamental paradigms just do not seem to work anymore.
Fear is driving the bus. Brokerage houses begin massive layoffs. Lawsuits are many. Congressional hearings and Securities & Exchange Commission investigations surface. The government tries to shore up public confidence and the Federal Reserve will inject large doses of liquidity into the market.
A sharp rally or two will make the public think that it is all over and that the market has recovered. Each up day is accompanied by the market’s spin machine at the start of the new bull market. However, the bear is only playing possum. An honest reversal can only be confirmed after a serious market low has been tested and the test failed to exceed the previous low. Weeks and occasionally even months usually separate these tests before the true bottom is confirmed.
In the fourth period, when all false hopes are extinguished, panic sets in. Dwindling volume and gloom are the rule of the day. The stock market falls out of the public consciousness. Daily volume often will be down 40% to 60% as buyers become virtually nonexistent. This is a time for patience and caution. However, it is definitely not the time to attempt to engage in bottom fishing.
The final period of a bear cycle is marked by capitulation. This is the point where investors give up the dream of making their fortune in the stock market. It is a period of peculiar volume and panic selling as the long-term investors who had previously provided the support for stock prices suddenly begin to lose all interest in trading. When the retail investors finally begin to move their money out of the stock market and into certificates of deposit, a true bottom is finally being established.
While 90% of all stocks may have followed the 100-day moving average up, 90% of those will have now followed it back down. We have now achieved the apparent resolution of the bear market and the public has now fled the field. The market will appear to be ready to re-cycle. However, the bear still has one last breath. The capitulated bottom must be retested and hold before any bear market is complete.
THE MARKET TODAY
As of June 2009, the market has enjoyed a rally of tremendous proportions. However, if you look at a chart of the S&P 500, you will see that the market hit a low of 739 in the week of Nov. 11, which was tested and exceeded when price action reached 665 on March 6, 2009. This is a market poised to test again and provides one of three options:
1) The market will strengthen and the rally will continue above the 200-day moving average as a new bull cycle is reborn. Confirmation will once again occur if the price action of the S&P can take out the 18-period moving average on a monthly chart. If this comes to pass, the recession that started in 2008 will bottom out in about September. The national economy normally rebounds approximately six to 10 months after the stock market bottoms.
2) The price action will test the March low of 665 and fail, completing a head-and-shoulder formation in the area of the November low of 739. Should this scenario play out, when we take out the aforementioned 18-period moving average, we will have confirmed a new bull market.
3) If we take out the March low of 665, pass out the parachutes. Technically, support sits at 640, 470 and 320. Pick your poison. Only time can tell how this scenario would shake out. The answer will, as always, depend on the fundamentals of the economy.
Historically, the average bear market lasts nine to 11 months. Of the gains achieved in the typical 40-month bull market, where approximately 90% of all stocks follow the 100-day moving average higher, more than 90% of these profits will end up being erased in the subsequent bear market.
As we analyze the bear cycle, it is a good time to consider the lemming and the traits it shares with traders. Lemmings, as the legend goes, are rodents that periodically drown themselves in the Arctic Ocean, en masse. The uninformed usually consider this phenomenon an insane mass suicide.
However, there is some logic to this apparent madness. First, lemmings are possessed by an overwhelming urge to follow. In addition, they are ravenous creatures and their reproductive rate is so high that, because of their constantly expanding population, they must migrate in search of food. After all, it takes a lot to feed 250 million lemmings every day.
Since lemmings can swim, when they come to a lake or river, they simply swim across it and continue on the other side in their endless search for food. As their migration continues, other lemmings join them. When they reach another small lake or river, they will repeat the process. This will go on for countless lakes and rivers. They likely come to believe they are quite good swimmers.
Finally, they unfortunately reach the Arctic Ocean. They probably think the ocean is just another lake. Their last thoughts may be something like, “Another lake? It sure is big! Oh well, 250 million lemmings can’t be wrong.”
However, not all lemmings die. There will always be a few that could not crowd into the water. There will always be survivors left to once again repopulate the world. When there are enough, they will again run out of food and begin to migrate. In the case of the market, rest assured, there will always be enough greed left in the world to start the drill all over again.
Aubrae de Buse has been engaged with the markets off and on since 1959 and is presently a proprietary trader for a family foundation.