HOW TO PROFITABLY TRADE BULL AND BEAR MARKETS?

Now that we agree on what the trend is in the market, we can go to the next step. Remember that a bull market is defined as a market that is making higher highs and higher lows. A bear market is a market that is making  lower highs and lower lows. A neutral market is defined as any other condition.

The highs and lows can come in any order. So, we could make two highs followed by two lows. Generally, however, we oscillate between highs and lows such that we make a high, a low, a high, and then a final low. But remember, it doesn’t matter in what order the highs and lows occur.

At the top of the chart in Figure 2.3, look at the high in August. I’ve labeled the first four highs and lows. Note that in this case, the second high is lower than the first high; we can say that we are making lower highs. Also note that the second swing low is lower than the first low. Thus, we can say that we are making lower lows. This is the definition of a bear market.

My concept is very simple but powerful. We must always be long in bull markets, be short in bear markets, and stand aside in all other markets. This is the basis for the most profitable technical analysis. We only need to look at the two most recent highs and two most recent lows to determine if it is a bull, bear, or neutral market. The analysis is updated every time a market makes a new significant swing high or low.

That new swing high or low is added to our analysis. Usually, that new high or low simply confirms the current analysis but sometimes it changes the trend.


The fifth circle on the chart is a lower low than the previous low, so it merely confirms what is already a bear market. But look at the sixth circle. It is a higher low. So, at that point in time, the market is making lower highs but higher lows. So, it’s a neutral market, right? The market then breaks lower and the next circle is a new lower low and the bear market is back in place.
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The Fall Of The Great Bull

Coupled with an extended bull market, the enactment of ERISA had the effect of codifying modern portfolio theory (MPT) in the eyes of the majority of investors and investment managers. (In a nutshell, MPT emphasizes that risk is an inherent part of higher reward, and that investors can construct portfolios in order to optimize risk for expected returns.) For fiduciaries, the concept of controlled risk through diverse asset allocation is certainly appealing. When markets are “behaving” (as they were for nearly two bullish decades) the return, risk, and correlation assumptions used to generate asset allocation analyses tend to sync relatively well with market activity; a trend is predictable as long as it continues. In this environment, modern portfolio theory became the comfortable thread that held the financial markets’ complex patchwork quilt together. Within this model, asset managers that performed well on a relative basis within a single, easily identifiable style could consistently raise assets. Once they stepped away from their advertised style, however, their opportunities became limited.

An unfortunate result of this phenomenon was that this narrow, restrictive environment tended to limit the growth of asset managers’ skill base. It’s difficult to understand how talented, competitive individuals allowed themselves to remain locked into one specific management style for so long, especially when that style had clearly fallen out of favor. I saw managers literally go out of business rather than change their investment approach.

As the great bull began to show signs of strain and the equity markets began to behave with far less certainty (no longer trending up). It became apparent that the relativistic, MPT-driven business model embraced by traditional asset managers—one in which money was managed on a relative basis, track records were marketed based on relative performance, and performance was measured in relative terms—was plagued by significant weaknesses.

Alexander M. Ineichen of Union Bank of Switzerland (UBS) estimated that total global equity peaked at a little over $31 trillion at the top of the bull market, falling to approximately $18 trillion at the 2002 low—a decline of approximately 42 percent. As during the 1974 period, the investment community reluctantly began to embrace change in order to cope with the divide that opened between the objectives of traditional money managers and the needs of their clients.

One of the prime causes for this divide was that MPT depends on “reasonable” assumptions for each asset class. Implicitly, this requires a very long-term view; investors must plan on holding their investments for a long time in order to reap the desired rewards. Unfortunately, when markets failed to cooperate toward the end of the bull market, it became evident that most individuals and institutions have a vastly different perspective of what “long-term” means, especially when short-term performance is on the line. During times of market stress, the correlations between asset classes often fall apart, which often results in unexpectedly poor performance.
Read More : The Fall Of The Great Bull

Bull Markets

A bull market, named for the animal that charges ahead, comes after a lengthy and substantial decline in stock values that comes about due to a downturn in the economy or a recession. Major market advances are usually, but not always, divided into three phases. These phases are marked by who participates in them and what they are doing in each phase.

1. Accumulation Phase. In the first phase of a bull market, there is accumulation of stocks or buying over a period of time, during which very knowledgeable investors with good foresight about a coming business upturn, begin buying stocks offered by pessimistic sellers who want out. This group of knowledgeable buyers will also start to pay higher prices as the willing sellers exit. The economy and business conditions are still often quite negative. The public, and this is mirrored by the financial press, is quite disinterested in the market, to the point of where owning stocks is very unattractive to them and they are out of the market. The people who lost money in the last bear market are actively disgusted with the market. Market activity is modest at best but is picking up a bit on rallies, but this is mostly only noticed, if at all, by professional market participants.
2. A Steady Climb. The second phase is one of a fairly steady advance, but one that is not dramatic. There is a pickup in business and encouraging economic reports as an improving economy leads to a pickup in corporate earnings. This phase is also a period where money can be made relatively safely, as technical indicators turn positive and there is an absence of volatile trading swings.
3. Main Street Adopts Wall Street. The third phase, which at one and the same time can be both highly profitable and ultimately risky, is marked by heavy public interest and participation in the market. The economic news is good during this period, and suddenly, front pages of magazines have articles heralding the new bull market. The new stock issue market gets going as the public now has an appetite for new companies. This is the phase where you will hear banter at parties about the stock market, how well so-and-so is doing in stocks and where, today, market-related Internet chat rooms are quite active. Price advances can be huge and volume is equally large. The more speculative stocks continue to advance but it is here that the blue chip stocks of the most established big-name companies start to lag the overall market. Some sharp downswings occur among stocks that fall out of favor. Speculation is intense as seen in increased option activity, the first-day closes of hot new issues and in the level of buying stocks on margin. The end of this phase is always the same, varying degrees of collapse. This can come after a year or two or even after several years have passed from the beginning phase.

Read More : Bull Markets

Bear Market

The general, but not universal, consensus is that a bear market occurs
when the broad market is down by 20 percent or more from
the previous month for a “sustained period of time”—usually two
or more consecutive months. Some folks place the decline at 15 percent
or more; however, the 20 percent number is more common.

That’s the technical definition. What matters to you is that
the broad markets, and most likely your portfolio, are dropping like
rocks and “investor confidence” is right behind them.


MARKET CORRECTIONS
You have to understand the definition of a bear market in order to understand
the underlying causes. Bear markets and “market corrections”
are not the same. Market corrections are declines of short duration, although
they can be severe.

The Standard & Poor’s 500 Index (S&P 500) lost some 10 percent
of its value in just a few days in October 1997. Investors in that month
had to decide if this was a market correction or the beginning of a bear
market. Investors who panicked and dumped stocks for “safer” havens
like bonds and cash instruments watched the market roar back, which put
them in the unenviable position of selling low, then buying high to get
back in the market. Investors who rode it out saw continued increases
until things began to unravel in the spring of 2000. Of course, they then
faced the same question again. This time it was a bear market.

THE PSYCHOLOGY OF BEARS
Bear markets are not just movements of stock prices in a downward direction.
They also represent a state of mind in the investing community.
During the roaring bull market of the 1990s, the general mood of
investors was that stock prices were going to continue to rise. Your entry
point didn’t really matter because prices were going up. No rational investor
will admit to this mindset, but investor confidence was very strong.
No one wanted to be sitting on the sidelines while the markets, particularly
the Internet/tech stocks, were flying high.

In a bear market, the reverse is true. Investors expect prices will keep
falling and take measures to protect their portfolios. Part of this protection
usually means dumping higher risk investments for more stable ones.
This pressure to sell only adds to the momentum of a declining market.


It usually takes time and sustained good news for a bear market to reverse
itself. As we said, this is one difference between a bear market and a market
correction.

THE RECEDING BEAR
A bear market and an economic recession are not the same things. Although
many of the same factors cause both, the stock markets do not always
move with the economy, nor does the economy always move with
the markets.

For example, analysts usually consider low unemployment good for
the economy because more people are working and they are buying more
goods and services. However, the stock market may view low unemployment
quite differently. Low unemployment means employers must compete
for workers, causing wages to rise. Rising wage rates may drive down
profits.

Investors purchase a stock based on the expectation of future profits.
If those future profits are threatened, the stock’s price may drop as
buyers look elsewhere for growth. Of course, it’s not quite that simple.
Rising wages can bring on inflation, which is one of the major causes of
bear markets.


This is not to suggest there is no connection between recessions and bear
markets. Sometimes a bear market will lead the economy into a recession
(after all, investors are betting on the future). Other times a bull market
can appear to lead the economy out of a recession: The 1990s bull market
began in the middle of a recession.
The point is that investors should look closely at the factors pushing
the markets toward a bear state of mind.
Read More : Bear Market

BEAR HISTORY

Bear markets are part of the history of the stock market. They occur often
enough for many observers to include them in an ongoing cycle of boom
and bust.

The biggest bear market occurred in the 1929 to 1931 market crash,
when the market lost almost 90 percent of its value. This devastating loss
of wealth and the accompanying depression shaped our history for
decades. It took the deficit spending of World War II to get the market
back on a sustained track. However, even that didn’t last long. The mid-
1950s saw the first modern bear market, the first of nine, not counting
the one that began in 2000.

Tips

Deficit spending spurred the economy by making the U.S. government
an active buyer of goods and services to support the war effort. Deficit
spending, however, can have the opposite effect when taxes are raised to
pay the increasing debt.


The sustained bull market of the 1990s convinced many of the 50 million
Americans who own stock that they were on a one-way ride to a comfortable
retirement. The 10-year run also convinced many people who
had never invested in the stock market before to give it a try. Many were
totally unprepared for what happened.

The stock market, led by Internet and technology stocks, was highly
overpriced. When investors failed to see the profits they expected from
these rising stars, they panicked and began a sell-off that drove prices down
dramatically. Uncertainty spread to other parts of the market, and the bear
was loose.

Unfortunately, history has a way of repeating itself at the most awkward
times. If they had looked at the following chart of bear markets since
the 1950s, they might have been better prepared for what was coming.
This chart shows the nine bear markets leading up to the bull market of
the 1990s. Many investors might remember the beginnings of a devastating
bear market of 1987 and Black Monday, when the market plunged
hundreds of points, as the worst in modern history. The chart clearly
shows, however, that it was only the third worst, and its recovery was
much quicker than previous bears.


Many observers called the bear market that began in 1973 a “super” bear,
in part because it occurred during a period of high inflation and because
of the lengthy recovery. Pity the poor soul who had planned to retire during
this period. After investing for many years, a long, painful bear market
takes almost one half of her portfolio’s value, and inflation takes a big
bite out of the remainder.

Losing one half of your retirement nest egg would be devastating.
Could it happen again? It most certainly could.

C a u t i o n
Don’t believe the popular notion that “things are different” now and
bear markets will not be long-lived or too severe. No one knows that for
sure.
Read More : BEAR HISTORY

A BEAR LESSON

The previous chart makes it all too clear that investing involves risk.
(We’ll look at this in more detail in Chapter 2, “Investing as a Contact
Sport.”) If you look at those nine modern bear markets beginning in 1956
and ending in 1990, you will notice that during this 34-year period, investors
have struggled with bear markets about 25 percent of the time.
Contrast that with the 10-year uninterrupted run of the last bull market,
and it’s easy to see how investors became overconfident.


This overconfidence, combined with little experience with bear
markets, left many investors wondering what hit them. The classic mistake
for inexperienced (and even experienced) investors is to watch prices
rise in a bull market and buy near the top. Then when the market heads
south, they follow the stock down and sell near the low. A “buy high and
sell low” strategy is no strategy at all.

Many folks writing about bear markets encourage investors to sit
tight and ride out the storm. This may make sense if the investor is 30
years from retiring, but the poor soul we mentioned earlier doesn’t have
the luxury of riding out a bear market—she can’t wait five years to recover
her loss. The only way she can meet her immediate needs is to cut
her losses as quickly as possible and retreat to safer investments, such as
cash and bonds.

The lesson of the modern bear markets is that what goes up can and
almost certainly will come down. Investors need to be prepared.

SLAYING BEAR MYTHS
Not all bear markets are the same. However, it is important to slay some
basic bear myths before we go any further;
■ Everyone loses in a bear market. We’ve defined a bear market as
including most of the market leaders, such as the bellwether S&P
500. Not every stock or even every stock sector loses money during
a bear market, and there are always stocks that do poorly during
bull markets. The cliché that a “rising tide lifts all boats” is not
true in the stock market.


■ You can see it coming. You can’t. Bear markets are notorious for
disguising themselves. Market corrections, which we discussed earlier,
are great decoys for bear markets: You never know when a market
correction is going to escalate into a full bear market. In our

earlier example of 1987, investors faced a sharp market decline.
Was it a market correction that would rebound shortly, or the beginning
of a continual decline into a bear market?

■ Bear traps are false signals sent by the market that suggest it isabout
to reverse course and head up. A bear trap occurs when a
stock drops sharply and panicked investors sell near the bottom,
only to watch the stock rebound. The broad market can execute
bear traps also. A straight-line drop in prices seldom marks a bear
market. Most often, prices will fall, then rebound to a level near
the original point, and repeat the pattern over and over. However,
the long-term trend is that the rebound never quite regains all the
lost ground.

Casinos use a version of the bear trap on their slot machines.
You put in three coins and pull the lever. A ringing sound means
you won. However, when you look in the tray, the machine has
only returned two coins. This incremental loss doesn’t seem as bad
as not getting anything back, so you’re encouraged to try again. In
the stock market, this type of incremental decline is a perfect disguise
for a bear market.

■ Bear markets can be averted. It’s preposterous to think we can
control the stock market. If we could control the stock market,
there would never be any bear markets. Actions can encourage or
discourage bear markets (such as interest rates and taxes), but there
are no controls. In Chapter 3, we’ll discuss the causes of bear markets
in more detail. We may even need bear markets to bring down
stock valuations to more reasonable levels, thus setting up future
bull markets.

The Persian Gulf War caused the bear market that began in
1990. Oil prices escalated along with interest rates. Rising energy
prices often lead to inflation. All these factors negatively affect the
stock market. Toward the end of the 1990s bull market, the Federal
Reserve Board (the Fed) raised interest rates six times and oil
prices escalated. Many feel the Fed went overboard in its attempt
to cool the economy and precipitated the bear market.


■ The Fed is responsible for the stock market. The Fed is not responsible
for the stock market, although it watches the market
closely. Fed pronouncements about the economy and interest rates
are widely followed by investors. The Fed views its primary responsibility
as controlling inflation. Inflation is a primary cause of bear markets, but the Fed is more
concerned with the whole economy. Inflation is deadly to any
economy and benefits virtually no sector. The Fed of course knows
that raising interest rates could eventually hurt the stock market,
but inflation hurts everyone.
Read More : A BEAR LESSON

BEAR-PROOFING YOUR PORTFOLIO

You can run, but you can’t hide from a bear market. The ugly truth investors
discovered after the recent bull market ended is that you can and
will lose money at some point if you stay invested for any length of time.
That’s the bad news. The good news is that you can protect your portfolio
from the worst effects of most bear markets. The trick is knowing a
bear market from a market correction.


RISK AND INVESTING
Despite all the talk about a “new economy,” there are fundamental truths
about investing that haven’t changed. The first is that investing involves
risk: There is a chance you will lose money. The more you stand to gain,
the higher the risk.

It’s ironic that an investing community that watches and benefits
from markets climbing to dramatic heights is shocked when they collapse.
The Nasdaq Composite Index went from over 5,000 to 2,600 is less than
a year. People were shocked and angry. Those same people didn’t mind
when the index was up 80 percent the year before!


LOOKING FOR BEAR SIGNS
Investors should watch a number of market and economic indicators for
signs of a bear. Unfortunately, it is not always easy to identify bear markets,
because not all bear markets are equal. Interest rates cause some; others
find a home during a recession; some are triggered by political unrest
or a war that no one saw coming—the invasion of Kuwait (as well as other
factors) triggered the bear market of 1990.


When markets become overpriced, watch out. At least, that’s the conventional
wisdom. Market observers repeatedly sounded the warning during
the 1990s bull market, but if you had heeded the early warnings and retreated
to safer investments, you would have missed most of the strongest
bull market in history. When the bubble finally burst, pundits were shaking
their heads with an “I told you so” attitude. Like the boy who cried
wolf too often in the fairy tale, eventually they were bound to be right.


AVOIDING TRAPS
“Bear Traps,” deals with three difficult issues for investors:
■ Market timing, or trying to buy at the absolute low and sell at the
absolute peak

■ When to sell a stock
■ When to sell a mutual fund

Market timing is a disaster waiting to happen for investors who think they
are smarter than the market. No one, no matter what they say in their advertising,
can consistently call the market correctly, and neither can you.
You don’t know where the top is and you don’t know where the bottom
is. (I don’t either.) However, there are solid ways to make investment decisions
that take the guessing out of the process. Bear markets, as noted
earlier, often disguise themselves as corrections or something else.

There are two sides to every investment decision: when to buy and
when to sell (although the buy decision seems to capture more attention
than the sell decision). Protecting your portfolio may mean moving out
of one class of investment and into another. Do you have an exit plan? We
will look at the process of selling stocks and mutual funds in detail.


BEAR YOUR ASSETS
You know that diversification is a powerful safeguard against an unstable
market. Asset allocation is how you go about that diversification. Many
investment professionals maintain that how you allocate your assets is
more important than picking the individual assets. As a rule, you want assets
split among stocks, bonds, and cash. A number of factors determine
how much you should allocate to each.

BEAR TRACKS
“Bear Tracking,” takes a look at some strategies from two perspectives:
age and time horizon. Our poor soul at the beginning of this chapter
who lost one half of her retirement portfolio the year she planned to


retire would have benefited from reading these chapters. We will look at
short-term strategies in particular, since almost everyone has financial
goals that are less than 20 years down the road.
Are bear markets a time to pick up some bargains on decimated
stocks? This strategy walks very close to market timing; however, with the
proper research, you may find some roses among the thorns.

BEAR DEN
Investors nearing retirement are the most vulnerable to bear markets because
they have less time to ride out the storm. What strategies should
you use and when? Part 5 discusses the concerns of pre-retirees and follows
them through retirement. You worked hard and invested wisely so
you could enjoy a comfortable retirement. Don’t let a bear market rob you
of that goal.

Are there “safe havens” in a bear market? Although there are no
completely safe places to hide, you can protect yourself from the worst the
bear has to offer.

BEARSKIN RUG
“Bearskin Rug,” discusses the three major considerations in surviving
a bear market and gives some examples of why they are so important.
These tools and techniques will help you avoid the worst the bear
has to offer. However, there are no “silver bullets” that are guaranteed to
kill the bear.

Investing is about risk, and nothing will change that. You can arm
yourself with information and education so you can make investment decisions
with a reasonable knowledge of their outcome.
Read More : BEAR-PROOFING YOUR PORTFOLIO

What is Bullish & Bearish Volume?

There are only two basic definitions for bullish and bearish volume:
1. Bullish volume is increasing volume on up moves and decreasing volume on down moves.
2. Bearish volume is increasing volume on down moves and decreasing volume on up moves.
Knowing this is only a start and in many cases not a great deal of help for trading. You need to know more than this general observation. You need to look at the price spread and price action in relation to the volume.

Most technical analysis tools tend to look at an area of a chart rather than a trading point. That is, averaging techniques are used to smooth what is seen as noisy data. The net effect of smoothing is to diminish the importance of variation in the data flow and to hide the true relationship between volume and the price action, rather than highlighting it!

By using the TradeGuider software, volume activity is automatically calculated and displayed on a separate indicator called the ‘Volume Thermometer’. The accuracy of this leaves you in no doubt that bullish volume is expanding volume on up-bars and decreasing volume on down-bars.

The market is an on-going story, unfolding bar by bar. The art of reading the market is to take an overall view, not to concentrate on individual bars. For example, once a market has finished distributing, the ‘smart money’ will want to trap you into thinking that the market is going up. So, near the end of a distribution phase you may, but not always, see either an up-thrust (see later) or low volume up-bars. Both of these observations mean little on their own. However, because there is weakness in the background, these signs now become very significant signs of weakness, and the perfect place to take a short position.

Any current action that is taking place cannot alter the strength or weakness that is embedded (and latent) in the background. It is vital to remember that near background indications are just as important as the most recent.

As an example, you do exactly the same thing in your life. Your daily decisions are based on your background information and only partly on what is happening today. If you won the lottery last week, yes, you might be buying a yacht today, but your decision to buy a yacht today will be based on your recent background history of financial strength appearing in your life last week. The stock market is exactly the same. Today’s action is heavily influenced by recent background strength or weakness, rather than what is actually happening today [this is why 'news' does not have a long term effect]. If the market is being artificially marked up, this will be due to weakness in the background. If prices are being artificially marked down it will due to strength in the background.
Read More : What is Bullish & Bearish Volume?