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Bear
Market Management (It's Not An Upside-Down Bull) |
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Some
day for stocks on Friday, huh? The market took it on the chin ...a
dip of 2% or more for all the major indices. Had it not been for Friday,
we would have ended the week with respectable gains. The question from
here is simple - what's next for stocks in the shadow of Friday's strong
selloff? There's no absolutely certain answer, but we've got some thoughts
on the matter today.
 Above
all else (and I don't want to come across as a fear monger) I
do think we're in a bear market. Equally important is this ...I
don't think it's a reason to abandon your trading activity. In my memory
I've made as much money in a bearish environment as I have a bullish one.
I've just had to adjust my strategies a little to do so.
Not
that this is a complete list of things I'm starting to do, but here
are a few things to think about just in case we go from bad to worse.
In
most of Bill O'Neil's books about his CANSLIM method he points out how
3 out of 4 stocks move the same direction as the market. Ergo, if we're
truly in a bearish phase, the odds of successfully going long on a stock
are about 1 in 4. You may indeed be holding that '1 in 4' stock, but that's
a tough bet to make.
Rather
than look for the 25% of stocks able to buck the bigger trend, why not
just profit from their declines? There are a handful of ways to do
this now, and they don't necessarily require an advanced trading account.
Starting
with the easiest and moving to most complex, the key ways to profit from
a falling market or stock are...
1)
Go long with an inverse exchange-traded-fund (ETF). This just means
you can buy an index ETF that goes up when the market goes down. If you
can buy a stock, you can buy these ETFs in your account. ProShares and
Rydex both offer these now, and there are others out there as well. If
you wanted to improve your alpha a little more, you can also buy leveraged
inverse ETFs, and even leveraged inversed sector ETFs.
2)
Buy put options. If you're not a fan of options because you think they're
risky, think again. They're different than stocks, but I don't think they're
any riskier if you manage them the right way. Anyway, put options gain
when the underlying stock or index falls (whereas a 'call' option increases
in value when the underlying instrument rises).
3)
Sell stocks short. I mention this possibility last because I think
shorting stocks carries more risk than owning options. Theoretically
the risk is unlimited with shorting stocks. Given the risk versus the
relatively limited reward potential, I'm not a big fan
of shorting stocks, though I know some of you have done well with it.
As
with any kind of investment, these bearish ideas have limitations and risks.
Just be sure to understand your downside and upside first before doing
any of them.
One
of the things I've seen more than once is the overuse of leveraged ETFs.
If 1/3 of your portfolio is long on a leveraged inverse ETF and the other
2/3 is invested directly in stocks, you basically have a wash - the gain
on one negates the loss on the other. That's great, but obviously not a
long-term solution.
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Understand
the Environment |
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I can't
count the number of times between March of 2000 and October of 2002 I heard
the 'ultimate bottom' had been made....it was at least six, though
only the last one was right (but even so, not confirmed until March of
2003).
 It's
not as if these people were off-base in their predictions - they were just
trying to do something the market doesn't lend itself to ...which is
being predictable. In almost all cases we saw a short-term bottom
made at the time we heard the word 'capitulation'. And, stocks rallied
sharply shortly afterwards. The problem was, stocks then proceeded to
even lower lows.
The
flaw in their logic was this - a bear market is not an upside-down bull
market. Bull markets tend to generate long, drawn-out uptrends.
Bear markets are notorious for wild swing (both bullish and bearish), which
can fake you out if you're applying strategies only effective in a bullish
environment.
I don't
recall from where or whom I first heard this, but I completely agree with
it...be an investor in a bull market, and a trader in a bear market.
This mostly has to do with timeframes. You generally can't hold the bag
too long in a bear market. Take profits when you have them, or you run
the risk of the next bearish retreat.
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Forget
The News-Badgered Names |
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If
you think the media makes it tough to trade high-profile stocks in a bullish
environment, wait until you see these stocks when things get ugly.
I don't recall the last time I saw the thirty stocks in the Dow Jones Industrial
Average trade this inconsistently, and these are some of the biggest
and allegedly the best names we've got to choose from.
 Though
not by a lot, the mid-caps have actually been the top U.S. performers
since the beginning of the year.
You
know what though? Foreign stocks have been even stronger performers.
Canada and most Latin American markets have easily topped U.S. stocks over
the last couple of months, and they could continue to do so indefinitely.
Regardless,
I'm seeing some interesting charts pop up from a lot of U.S. names I'm
not familiar with. Many of them seem to be from the Russell 2000 index,
or maybe even smaller than that.
Is
this a potential conflict with suggestion #1 'Go With The Flow'? On
the surface it may seem like it is, but I don't think it is in the grand
scheme of things.
The
1 out of 4 stocks that will survive and even thrive in a bear market have
to come from somewhere. Don't be stubborn about it, but if you think you've
found one, then you think you've found one. By studying market cap
and sector performance (birds of a feather flock together), you have a
much better shot at finding the rare winner in bear market.
Some
final thoughts for today (though we've only scratched the surface)...
 Many
of you have asked why I think we're in a bear market. My rationale is very
simple - results.
You
know the 200 day moving average line I often plot on our market index charts?
I
use it because it's an inarguable indicator of long-term results.
Well,
not
only are all the indices under their 200 day lines, but the 200 day moving
average lines are falling - sharply. We've seen this happen
a couple of times between 2003 and now, but never this badly (or for
this long).
Bear
in mind this still leaves room for upside swings, like we discussed in
part 2 today, 'Understand The Environment'. In fact, you may be
surprised to know the market produces more huge single-day rallies and
short-term bullish swings in a bear market than it does in a bull market.
Don't
get married to one of those moves ...it'll probably be short-lived. I think
if we even get to retest the 200 day lines I'd use it as an exit point
for longs, and an entry point for shorts.
Others
of you have asked how will we know when the market is primed to make one
of its many reversals during a bear market? I'll refer you back to one
of my favorite tools - the ISE Sentiment Index.
 The
ISE index is a contrarian tool, meaning when traders are most fearful it's
time to buy, and when they're most confident it's time to sell. The strategy
seems to work even better in a bear market, since emotions are already
intense.
The
nearby chart explains why I like this tool. Is it perfect? No, but
it's a great way to get a feel for when the buyers or sellers are reaching
their short-term limits. The plunges in the ISE Sentiment reading usually
occur a couple of days before the bottom is actually made, though the tops
for the ISE reading and the market tend to occur simultaneously.
Based
on the current chart, I don't really think we're at a trade-worthy short-term
bottom yet, but I know we don't have enough optimism to start thinking
we're at a major top.
By
the way, my other favorite way to spot short-term tops and bottoms in any
environment is though Fibonacci retracement levels.
In
the near-term (several days) I'm looking for more selling. In the intermediate-term
(weeks) I think we'll see a pretty strong recovery rally...and perhaps
a retest of the 200 day lines. In the long-term (months), like I said,
I believe we're in a bear market.
OK,
now that we've opened up several cans of worms, we're looking forward to
closing them in upcoming editions. Be sure to check out the
blog often as well...we can add more details there than we can in the
average edition of the newsletter.
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