If this is a newly born bear market this article shows how to deal with it
Istanbul has me now
Actually it doesn’t any longer, since I got back from Istanbul today (Sunday, October 4).
During my four nights there, I was asked in an e-mail whether I thought the downturn on the stock markets would be “smooth like in 2008” or exhibit a “small bounce by 10% now”.
True to form, I immediately replied I thought the current downturn probably will be interspersed by at least a dozen dead cat bounces of 10-15% each, just like during the last two bear markets.
You can take my word for it that’s how it usually plays out.
On the other hand, then you’d be taking this guy’s word, which might not be wholly recommendable…:
Bear market bounces, a.k.a. bull traps
Instead of trusting Mr Surfer above, check out these two charts, where I’ve highlighted bounces of approximately 10% or more.
If intraday data is counted, there are several more bounces. The following, however, is enough support for the thesis that you should expect much more than just a handful of large bounces during a short cyclical bear market:
Don’t worry about the US centric choice of charts. E.g., the Swedish OMX index exhibits the same pattern. The same goes for downturns in general. No matter differences in economic exposure, valuation levels etc.; where the S&P goes, the OMX goes too.
How to trade a cyclical bear
First, you have to decide whether you think a bear market is in the works or not.
I think the bear market has started, for several reasons: The bull market was getting long in the tooth, valuations are ridiculously high, market dispersion has increased, key moving averages were broken decisively during the drop in August, other markets have already signaled distress (oil, e.g.).
You may not agree. If not; as you were.
Second, should you care at all? If you strictly adhere to the “Buy and Hold” investment strategy, the answer is no. Just don’t change your mind any later than now. Actually, even a BAH investor can benefit from a road map for timing stock purchases, so keep reading.
Third, if you do care, if you want to trade the bear, do you want to make money shorting, or just try to time a large purchase close to the trough?
I’m not recommending anything here, I’m just asking you to analyze yourself, and make a game plan before things heat up. Bear markets are not child’s play and it’s easy to lose one’s religion during market routs.
Regarding buying at the bottom, you won’t know when it’s time, just as nobody rang a bell at the top. However, if you start buying once the expected annual return exceeds 10%, and then accelerate your purchases when market dispersion falls (trend uniformity increases) and junk bond yields fall significantly, you should come close enough.
There are too many ways the bottoming process could play out for me to detail them all here, but no matter what happens, just focus on buying ‘cheap enough’ and make sure you get the risk aversion trend with you before going all in.
Aggressive bear trading
I will trade the bear much more aggressively than most. I plan to do it in a way I couldn’t recommend anybody.
To start with, 75% of my active portfolio consists of XACT BEAR (which is a Swedish stock index ETF with a negative delta of 1.5). Hence, more than 100% of my portfolio’s net value is short. The rest, around 25% is invested in gold. I also have all but negligible amounts invested in a couple of single stocks and cash earmarked for oil.
I plan to reduce my short position whenever stocks drop by 20% (from a recent peak or with a sudden new, steeper, trajectory), like in Q1 2001, September 2001, summer and fall of 2002, October and November 2008, as well as March 2009.
Then I’ll increase my shorts again, after a bounce by more than 10%, and even more if the bounce grows to 20%, like in the second and third quarters of 2001.
Once the total drop amounts to around 50-60%, I’ll focus more on reducing my shorts after sudden plunges than putting them back on again after bounces and surges.
However, my main indicators for when to start going long in earnest, are market dispersion (industry, Advance/Decline, new highs/lows, etc.), dropping junk bond spreads, various sales multiples (P/S, Mcap/GDP etc.) and long moving averages.
Given that markets don’t just revert to the mean, but invert the overshooting to undershooting below the mean (unless the average has shifted upward permanently), the current downturn could be even more vicious than even I expect. Nevertheless, if I can buy stocks on multiples promising 10%+ annual returns, I will (fully knowing there could be another halving waiting before the ultimate trough). The above factors, as well as time, will guide me.
I have a feeling this cyclical bear, the third and last during the 18-20 year secular bear that started in March 2000, will be extraordinary. I’m just not sure how. It could be unusually large reductions in value from peak to trough, it could be the number of bounces, the intensity of plunges and bounces (due to e.g. higher lending, more derivatives and much more and larger HFT accounts), or a more prolonged process, e.g. Or all of the above.
Anatomy of this bear
What follows is my current game plan for the current cyclical bear.
Peak: summer 2015
Trough: between July 2017 and July 2018
Total drop in value: -60% for S&P 500 to 850
# Dead cat bounces >10%: 15
Just as during the previous two cyclical bears, I think we’ll see progressively bigger drops, followed by correspondingly bigger bounces, until both the plunges and bounces moderate (like between September 2002 and March 2003) after a capitulation event like the one in June, July 2002. That kind of bottoming out process is likely to take place between the summer of 2017 and the summer of 2018, i.e. 2-3 years after the peak.
I think the Fed will feel forced to try a rate hike sooner or later. Perhaps to signal all is okay. Then they’ll backtrack due to a market plunge (that I plan to buy on, i.e., temporarily reduce my short positions) and launch a new QE program (#4).
I think the USD will strengthen during the market plunge, the flight to safety effect helped by the interest rate hike. I also think China will devalue its currency aggressively, intensifying the currency wars. That in turn will propel real assets upward: gold, bitcoin and oil (though the latter needs to get low enough first).
I plan to buy oil again once it starts falling in tandem with weaker macro data.
I have enough gold… I think.
High margin debt, and losses on derivatives will pressure stocks in a vicious circle of liquidation, culminating in a final death spasm, sending markets down a final 25% in a single quarter with revenue based valuations reaching typical bear market levels.
Very few will have the guts or the cash to buy stocks by then. I hope to be one of them.
If you held on to your stocks throughout the bear, they probably lost 60-70% in value over 2-3 years, but you can of course still buy more for whatever cash flow you produce. Let’s just hope your job is secure, interest rates or rents haven’t risen too much, or you’ve lost your faith in stock markets by then.
The bear is here
Decide whether to sell, or just buy (I have already sold)
Whatever you take away from this article, just remember the recurring pretty large bounces.
I don’t intend to try to time them perfectly, that’s impossible. However, I’ll still buy on dips and sell on surges and hope to make a little extra even if I sometimes miss out completely.
Also note that the plunges become larger and larger as the bear progresses.
Bear markets almost seem constructed to cause the maximum amount of pain for long-onlies and newbies.
Most of all, prepare a list of things to buy when (if) they get cheap enough. Start building the list right away – either alone, or with a group of trusted friends (or on the line for that matter).
Remember that the return of any investment should be positive for you, not just your bank account. If certain investments or investment decisions keep you awake at night for long periods of time, it’s just not worth it. You are supposed to manage your resource allocations in a way that adds value to your life.
Sign up for my (weekly-ish) newsletter, and I’ll keep you posted on my personal investment choices. Don’t expect a high trading style turnover rate, but perhaps a few well timed decisions taken with a bird’s eye view of the markets. Tell a friend too.
If you can’t control your finances or investments, at least you can control your body. That’s where your life begins, and that’s where it ends. The rest is just noise.
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