Three Things to Know About Bear Markets

 | Aug 22, 2011 | 8:43 AM EDT  | Comments
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You get recessions, you have stock market declines. If you don't understand that's going to happen, then you're not ready, you won't do well in the markets.

-- Peter Lynch

The market is set to open strongly this morning, but after the weak action over the last few weeks we are hovering close to bear-market territory. A bear market is generally defined as a downturn of 20% or more in multiple market indices. Presently the S&P 500 and the Nasdaq are about 18% off their highs so it won't take much more to push us into the technical definition of a bear market.

While it certainly is possible that the market will find some support here and turn back up, we need to be mentally prepared to deal with a bear market should we not see the quick recovery that so many are hoping for. While we might want to be optimistic that the worst is over, we also need to be practical and be prepared in case it isn't.

There are three things about bear markets that we should keep in mind:

1. Bear markets are not just the inverse of bull markets. Stocks go down differently than they go up.

Even if you are adept at shorting, one of the most challenging aspects of a bear market is that you can't just do the opposite of what you do in bull markets. Stocks don't go down in a bear market in the same manner that they go up in a bull market. Typically there is a higher level of volatility in downtrends, with sharper downside moves and bigger and faster bounces.

In a bull market you can usually be patient with positions and give them some time to work. In bear markets, your holding periods generally need to be shorter and your profit-taking more aggressive. The gains can occur much faster on shorts, but they can slip way extremely fast. The open this morning after the action last week is a good example of standard bear-market action.

Effective shorting generally requires a more anticipatory approach than good long trading. Chasing strong momentum tends to work better with longs, as the moves are usually more sustained and drawn out. With shorts the gains tend to come much quickly and don't last as long. If you aren't already in a short position, it is much more difficult to find entry points.

2. The sharpest rallies occur in bear markets.

If you look back at the history of the market, almost all of the biggest one-day moves have occurred during bear markets. The reason for that is because people simply aren't ready for them. The bulls are underinvested, the bears have profits to protect, and they suddenly rush back into the market thinking that maybe the bottom is finally in.

One of the things you often hear from traditional Wall Street is that if you miss out on the 10 biggest days in the market, you will underperform. What they never seem to mention is how these days tend to occur in bear markets and how you would have fared if you missed the 10 worst days and didn't hold when the market started to downtrend.

From a trading standpoint, these very vicious rallies can provide some great opportunities, but the key is to stay short term and to not be sucked into the inevitable proclamations that the worst is over. Folks understandably become hopeful very quickly when we have a big bounce, but the failure of those bounces is what produces the real pain of a bear market. Play the bounces if you are so inclined, but don't be too quick to trust them.

3. Bear markets are more likely to end with a whimper rather than a bang.

A third thing to keep in mind about bear markets is that the bottom is usually only obvious in retrospect. Many market players look for huge panic and selling capitulation to signal a bottom. This has occurred at times like during the 1987 when we had the one-day crash and the huge bounce the next day, but typically the lows occur without much fanfare.

In March 2009 we had dripped lower for several weeks after a month of waterfall declines and finally found a bottom on an unremarkable day. The bottom in 2003 was similar. We drifted down on lower volume and finally reversed up and volume surged. There was no panic or final washout.

I've often written that bad markets tend to wear you out rather than scare you out. What makes bear markets so dispiriting is when it feels like we'll never go up again. It is important to keep in mind the goal of the market beast is to always make us uncomfortable as possible. It wants us to give up out of disgust and despair. If you know that, it can easier to deal with.

Rather than fight the fact that we are in a bear market, embrace it -- you will deal with it much more effectively. Bear markets are never easy but they are inevitable, and if we can keep the damage limited we will profit greatly when times improve.

We have a decent bounce brewing this morning, but you sure can't be too trusting of an open like this on Monday morning. There are lots of "stuck holders" out there and they will be happy to sell. Gold at the highest price since 1898 is not a cause for great optimism.

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