Category: Best Of

13 More Thoughts about Bear Markets

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A couple weeks ago I shared some of my musings about market corrections. Here are a few more of them:

 

1.Bull markets reward risk-taking, but when the bear puts out honey, he is usually laying a trap.

2. In bear markets, indexes can remain oversold longer than most dip buyers could remain solvent. In bull markets, oversold market breadth readings lead to bounces. In bear markets, short setups often continue to work even during oversold conditions, especially during the initial stage lower.

3. Never say never. Absolutely anything can happen. Even stocks of the strongest companies can and will decline substantially during market corrections. When a market correction starts, some of your stocks will gap below your stops. Justifying holding individual positions below their stop levels, because the general market is oversold or might soon become oversold is not wise. Losses could escalate very quickly in a bear market. Act as a professional and take your next best loss. Not selling your losers means that you believe that they will outperform the rest of the available setups. Whether you are a trader or an investor, if you deal with individual stocks, you always need to have an exit strategy. If you can’t take a small loss, sooner or later you will have to take a very large loss.  Consider potential future winners you might miss because of the effect of a larger loss on mental attitude & trading size.

4. You could be right on a market and still end up losing if you use excessive leverage. Bear markets are very volatile. A small move against your overleveraged position could take you out. This is why averaging down in the midst of a correction is not for most people. It takes a strong stomach and a very deep pocket.

5. In bull markets, oversold technical readings lead to a bounce. In bear markets, you need a major news change like FED or ECB announcement for a rally. Some of the most powerful rallies happen below declining 200-day moving averages.

6. When you are in a losing streak, you can’t turn the situation around by trying harder. Go to cash in order to gain some objectivity. Take a break from the markets.

7. Buying stocks of companies, which products & services you love and use works great in a bull market. Not so much in a bear market.

8. Price action might impact fundamentals just as much as changes in fundamentals can impact price action. Sustained lower stock prices eventually lead to worse fundamentals in many cases. Low P/Es today often foreshadow lower earnings in the future.

9. Recency bias and placebo effect rule much of market’s action. Price action often defines the tone of news. Scary headlines tend to appear after markets break down. Positive headlines appear after markets bounce. With other words, the market is better at predicting the news than the news is at predicting the market.

10. Appreciate all trending markets – up or down. A downtrend is better than a choppy market. In fact, stocks tend to move a lot faster during corrections. Corrections are rare and a good trader knows how to take advantage of them. In fact, a good trader appreciates and loves corrections, because they provide incredible opportunities – first on the short and then on the long side. A correction is among the best things that could happen to a prepared trader with a plan of action.

11. When most people feel like buying the dip is a good idea, it is usually not. When most panic and start wanting out at any price, it is time to enter for trade. It is easier said than done. It is not something that can be quantified or explained. It is something that has to be experienced, multiple times. One hint regarding bottoms: they are made by heavy buying, not heavy selling (even though the latter is often a prerequisite).

12. 80% of bear markets or steep corrections is choppy price action, which might whipsaw both bulls and bears. Long bear markets make smart traders appreciate bull market a lot more, not take them for granted and take a lot better advantage when they come back. They always do.

13. Bear markets turn investors into day traders and traders into buy & hold investors. By the time a bear market is over, most active market participants are conditioned to take small gains. This might turn into a drawback in the initial stages of a recovery, when markets become less choppy and trend better.

Don’t worry about what the markets are going to do, worry about what you are going to do in response to the markets. In the end, we should focus on only what we can control: our market exposure, equity selection, entry, exit and position size.

Check out my book, CRASH – How to Protect and Grow Capital during Market Corrections.

10 Musings about Market Corrections

  1. Deep corrections last long enough to condition people to sell their winners quickly because of frequent reversals in direction.
  2.  Some say that If you don’t have a plan, you will become part of someone else’s plan. Well, the problem during corrections is that many are not able to follow their plan – not because they don’t want to, but because the market doesn’t let them. Hint – the gaps above and below your stops. The cure is to decrease our position size and the frequency of our trading.
  3. Market corrections come slower than most expect, but once they arrive – they escalate faster than most can imagine. Peter Lynch’s words are a good reminder here – “far more money has been lost while preparing for corrections than during the corrections themselves”. Keep in mind that most of Lynch’s career as a mutual fund manager took place during a secular bull market.
  4. The market is not going to be healthy all the time. 8% to 20% correction happen at least once a year every year. Steep corrections create incredible opportunities, but you have to protect your capital in order to take advantage of the recovery.
  5. Once in awhile, a correction will turn into a bear market. They say that both bulls and bears lose money during bear markets – bulls, because they stubbornly hold to favorite story stocks while they are crashing and then they give up near the bottom; bears – because they get squeezed by frequent face-ripping rallies under declining 200-day moving averages.
  6. All corrections feel the same. In the beginning, people don’t believe them, then as prices continue lower and weakness spreads to more sectors, fear escalates and it leads to forced liquidation. Forced liquidation means selling, because you have to, not because you want to. Smart investors dream to be on the other side of forced liquidation.
  7. At the lowest point of a correction, the fear of losing is substantially higher than the fear of missing out.
  8. During corrections, correlations often go to 1.00, which means that stocks move together up and down disregarding of individual merits. If a stock manages to hold its ground and consolidates through time or even make an attempt to make a new high, it is likely being accumulated by institutions. Because of the nature of their size, many institutions prefer to buy on pullbacks and during market corrections. Selloffs provide liquidity that masks their accumulation. Once the pressure from the general market is removed, those stocks tend to outperform.
  9. Bottoms are made by heavy buying, not heavy selling. Stocks not going down on what appears to be bad news is a positive sign.
  10. “It is not entirely clear what causes deep market corrections, but without them, many of the best performing long-term investors would have never achieved their spectacular returns.” – Peter Lynch

Is Cash Really A Position?

Josh Brown, who I tremendously respect, made an interesting comment on Twitter about going to cash in times of turmoil:

In this case, he does not refer to hedge funds or individual trading accounts, but to people’s retirement savings.

I can see why he would suggest that most investors should not go to cash and should continue the course of dollar-cost averaging each month:

First, past history shows that many investors are not very good at timing the market. Here’s Joel Greenblatt in the book Hedge Fund Market Wizards by Jack Schwager:

The single best-performing mutual fund for the entire decade was up 18 percent a year, on average, during a period when the market was flat, yet the average investor in that fund lost 8 percent. That is because every time the fund did well, people piled in, and every time it underperformed, people redeemed. The timing of the money flows was so bad that investors, on average, turned a fund that was making 18 percent a year into a losing investment. I think that says it all. Institutions make the same mistakes as smaller investors.

Second, achieving average returns would be a great success for many investors.

And third, many investors are likely to be reluctant to buy at higher prices. Psychologically, it is difficult to buy an asset at $200 if you sold it at $170. In life as in markets, if you want to achieve bigger than average results, you often have to do things that are psychologically challenging for the majority of people. If it was easy, everyone would do it and the potential reward would be much smaller.

These are all good arguments, but constantly staying 100% invested and diversified is not the perfect solution for many.

1. Some don’t invest in well-diversified ETFs and own individual stocks in their 401k in order to achieve higher returns.
2. Those that are well diversified geographically and in terms of market cap and non-correlated assets, also go through deep drawdowns because correlations often go to 1.00 during deep market correction. It doesn’t matter if you own Apple or Snapple. Your portfolio is getting hit during market panic. When your portfolio goes through a deep drawdown, you are very likely to panic and sell near the lows. What happens when you sell near the lows? You lose your confidence and you don’t take advantage of the recovery.

3. If you manage to minimize drawdowns during deep market corrections, you will be able to grow your capital faster and be in a better psychological position take advantage of much lower panic prices.

If you are an investor that prefers to ride some trends in a long-term perspective, you need to learn how to hedge. One simple way to hedge long-term holdings is to buy some short-term protection (put options or put spreads) when your stocks start to show signs of distribution and close below their 50dma.

If you are a trader, it is very simple. You diligently take your losses and make sure that they are small, so the size of your winners can overshadow them. As George Soros was famously quoted by Druckenmiller – “it is not important whether you are right or wrong, but how much money do you make when you are right and how much money do you lose when you are wrong”.

Is market timing possible? I believe it is. It is not an exact science, but there’s a process to the madness. There are some clear signs in the market that hint when it makes sense to raise cash, hedge and go net short – distribution days in major stock indexes, price action in market leaders, changes in market breadth, changes in trading results, etc. I wrote about them in more detail in my book Crash – How to Protect and Grow  Capital during Corrections.

To answer Josh’s question about “when do you get back”

There are a few things we will be watching ranked in terms of importance:

1. Stocks setting up on the long side are starting to break out and following
through. These are the next market leaders that we want to own
aggressively.
2. Multiple days of heavy buying in the major indexes: up 1.5% on bigger
than the average 50-day volume; the signal is much stronger if indexes
finish near the high of their daily range. Sustainable bottoms are formed by
heavy buying, not heavy selling.
3. A retest of the momentum low with a smaller number of stocks making
new 20-day lows or larger number of stocks trading above their 20-day
moving averages – with other words, a retest with some form of market
breadth divergence. Retests are not always necessary for a bottom to form.
They matter from a psychological perspective because they flush out the last
remaining weak hands in the market, which makes the recovery smoother
and faster.
4. The major indexes close back above their 200-day moving averages and
stay there. They start to move higher.
We could gradually increase our long market exposure depending on how
many of those points are met: 25% when point 1 is met; 50% when 1 & 2,
etc.

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