From the August 01, 2009 issue of Futures Magazine • Subscribe!

Riding the bear

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.

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