Know What Can Destroy Your Account...and also What Can't

At any given point in time, there is a myriad of potential causes for your investment account to get destroyed. This is no reason to seek shelter and reduce risk, however, as it is the very presence of risk that brings with it the potential for high returns. Investors frequently remain underexposed to market rallies, sometimes lasting years, because they do not have a system of identifying the true risks to their particular trading style and portfolio. Just as knowing the capabilities of your enemies will prepare you in battle, focusing on what may hurt your wealth is the best way to prepare and defend it.

The years 2007 through 2009 will stand in the memories of a generation of investors as proof that stocks can go down a lot further and for a lot longer than seems reasonable. The emotional scarring caused by these losses caused many market participants to sharply reduce their equity holdings in 2009 – after all, there’s nothing more humiliating than being burned twice by the same flame. In fact, stock funds have seen net outflows from retail investors so far in 2009, while bonds have seen net inflows – this is a clear sign of risk aversion. However, these same market participants had yet to formulate a plan to increase their risk exposure before a massive rally brought the market roaring higher off the bear market lows. Now, 2009 will also stand out as the year that proved that stocks can go up a lot more for a lot longer than seems reasonable.

Many market participants got caught flat-footed in the face of the now nine-month, 65%+ rally off the bear market lows because they have not properly assessed the inherent risks to their trading styles or portfolio. Right now, for example, there are plenty of people who have made some money back in 2009, but who are now selling or will sell at the first sign of trouble because they feel the market has simply gone up too much too quickly. While this may in fact prove to be true, they have failed to assess what this means for their holdings. Does it mean the market will go down 50%? 30% 5% Does it mean the market will go sideways for several months? How will this affect their positions?

Just as a bear in the woods must distinguish between the sound of shotgun versus a crash of lightning, stock market participants must distinguish what to fear and what not to fear. After all, if you recognize that the market is overbought and due for a rest or pullback, selling may not be a good idea, as the likelihood of just a mild, countertrend pullback may be quite high. Selling in such a situation would simply reduce your exposure during a healthy trend that is merely experiencing some consolidation, a pause of short duration – the risks of getting out too early cannot be understated, as a low-risk re-entry may never appear until the trend is over, and, as 2008 and 2009 have shown, you never know how long a trend will run.

How Bear Markets End

It is significant that just about anyone can spot a bear market after it has happened, but few have a methodology for defining what a bear market is, when it has begun, and when it has ended. Given the duration and severity of the declines in the current bear market, it is appropriate to analyze methodologies to determine when the bear market has ended and a new bull market has begun. You can find some of my material on the subject of bear market completions at Stockbee.blogspot.com – just do a search for my name in the ‘Search Blog’ field.

A successful methodology must simply catch the long-term shift from primary selling to primary buying by market participants. Because historic average volatility remained much lower than current levels for many years, the old definition of the start of a new bull market, any increase of 20% or more in a market, is not appropriate in the current high-volatility environment. Under the old definition, there have been three new bull markets since last October – clearly another methodology must be used in order to be useful in the real world.

So what is a good indication that the pendulum of the market has swung from down to up? First we must define the timeframe of the trend on which we wish to focus. Are we talking about a daily timeframe? Weekly? Yearly? To talk of trends at all is without meaning unless a timeframe is specified. We will focus here on the long-term timeframe, which covers the one- to two-year period. In analyzing the major bear markets since 1929 – the 1929-1932 Great Depression bear market, the 1973-1974 Vietnam War/Watergate bear market, and the 2000-2002 Tech Bubble Bursting bear market – several key factors have defined the end of long-term bear markets.

The first element is the market trading above a long-term moving average: the 200-day moving average. There is nothing inherently magical about the 200 DMA, but it does represent the average price of a relatively long timeframe (about 10 months of trading), and has proven to be a reliable tool in defining whether the market is trending up, down, or sideways. When using the 200 DMA, two things are important: the market price relative to the 200 DMA, and the slope of the 200 DMA. The market may break above the 200 DMA and remain above the moving average for days, or even weeks, as happened from August-October 1932, October 1973, and March 2002, while not changing the downward direction of the long-term bear market. However, once the slope of the 200 DMA has turned up and the market has crossed above the 200 DMA, each time, among the bear markets mentioned, the market has seen subsequent significant gains over the following months and years, and the bear market lows were not breached thereafter*.

The second element to define the end of a bear market is the ability of the market to breach the high point of the previous significant rally. This can only be accomplished when there is greater pressure from buyers versus sellers in a sustained trend. Clearing a prior high also means that everyone who bought and held since the prior high has made money – this tends to give market participants more confidence, so they continue to allocate more money to the market, thus reinforcing the new uptrend. Until the market successfully breaches a prior high, there is no way to know if the upward momentum is likely to continue, as the market’s strength has not yet been tested. Therefore, a new bull market, by definition, cannot take place without the market first trading above a prior rally high.

So, armed with this knowledge of bear markets, where does the current market stand in the long-term trend? Well, the S&P500 cleared the 200 DMA on June 1st by a margin of several percent, but the 200 DMA remains in a downward slope – strike one. In June, the S&P500 also tested its prior rally high made in January. However, after failing to close above the January high by more than a couple of points, the index then dropped 9% over the next few weeks – strike two. No new bull market there.

And how about the NASDAQ? In late-April, the NASDAQ breached its prior rally high made in January, and has remained well above the prior high ever since – first test passed with flying colors. In late-May it then breached its 200 DMA and has also remained well above the moving average ever since. However, the slope of its 200 DMA, like that of the S&P, is still pointing down – the bull market has not yet been confirmed.

So the US equity markets remain in long-term bear trends. Although the groundwork has been laid for the next bull market, it will likely take at least several months before a successful attempt at breaking the bear trend will occur. Currently at 883, even if the S&P500 stays in a range between 850-1000 for the next two months, the 200 DMA will only begin sloping up sometime in September at the earliest. Therefore, although it has had a run for its money, the bear market remains alive and is likely to remain the primary long-term trend for the foreseeable future.

*The 2002 lows were in fact breached in the current bear market, but not before the market rallied 70% after the 200 DMA began sloping upward.