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How investors can get wrecked in bear markets

by Giles Coghlan, Chief Currency Analyst at HYCM

Bear markets are broadly defined as occurring when asset prices drop by at least 20% from recent highs. Some measure them from an asset or index’s 52-week highs. Other definitions hold that declines have to be sustained over at least two months for the price action to be considered a bear market. Other features of bear markets include widespread pessimism and gloom regarding the prospects of the economy.

On March the 11th, the Dow Jones Industrial Average entered bear market territory after declining over 20% from the all-time highs it had set at the end of February. The S&P 500 followed suit the next day after gapping down, as did the Nasdaq. The Russell 2000, as it often does, presaged those moves by a couple of days. We have now fulfilled all of the above criteria except the length of time typically required for such a downward movement to be reclassified from a crash to a full bear market.

Volatile environments are usually favoured by traders who seek to capitalise on the huge swings in price that occur when markets, seeking a new equilibrium, surge and fall. However, for the same reasons trading at these times is incredibly risky. Below, you will find a few points to hopefully help you keep these risks firmly in mind while trading at this time.

No one can see the bottom

No matter what anyone tells you, be they a specialist of technicals or fundamentals, bottoms are only clearly visible in hindsight. As noted above, the markets haven’t even been dropping for the sustained 2-month period typically required to classify this move as a bear market. Yet, we’re already starting to see and hear analysts discussing bottoms and the possibility of the market bottoming-out. It’s probably best to try and filter out all of this talk at this time and to avoid trying to time a precise bottom to the market.

The allure of nailing a perfectly timed long at the bottom of a sell-off can be overwhelming, but such home runs are risky, their likelihood of success slim, and the risks involved can be enormous. As veterans often like to point out to beginners; “time in” the market is better than “timing” the market. The latter is more of a gamble that requires everything to go your way in a short period. The former suggests that if you get the trend right, even if your timing is not perfect, you will have traded in the overall direction that the market is taking. The very notion of trying to pick a bottom less than two months after the top is extremely foolhardy, especially considering that much of the world is on lockdown and crude oil futures just went negative for the first time in history.

The bear markets that followed the tech bubble of the late 90s and the Great Financial Crisis are just two recent examples that may help to illustrate this point. The S&P 500 peaked in March of 2000 following rampant speculation in the tech sector, but it didn’t bottom until September of 2002. The peak-to-trough decline was around 50% and it took about five years to climb back to those former highs. As soon as it did so, the first rumblings of the Great Financial Crisis began to be heard. The S&P 500 peaked once again in October of 2007 and hit its lows in February of 2009, again two years after the all-time high. Peak to trough the GFC decline was almost 60% and it took four years to reach those former highs.

It’s not always “just a correction”

In trading, it’s easy to confuse what you need to happen with what is going on. When an investment turns against you or was wrong to begin with, you can start filtering out all incoming data that contradicts your thesis and only give credence to the information that confirms your position. It’s amplified when a bull market suddenly turns and becomes a bear market. That is partly because, contrary to what logic would dictate, most investors tend to be overinvested nearer to the top.

When fully invested at the top of a market, many people tend to convince themselves that the inevitable bounce following the initial drop is proof that everything’s fine and prices are on course to reclaim their former highs. In the case of bear markets, this bounce is usually just the first in a long series of lower highs as the price continues to head south. In such a scenario, holding on and hoping that the market hasn’t turned is a sure way to lose fortunes. You have to be able to question what you believe about the market and – where necessary – make uncomfortable choices.

This is what we’re currently witnessing in the US stock markets, which are so often regarded as a proxy for the health of the global economy. The S&P 500 and Nasdaq are currently up over 28% from the lows they set at the end of March, and the Dow Jones Industrial Average is up almost 30%. It’s easy for those who held on during the recent crash to start convincing themselves that the worst is over, that we’re over the curve, that everything will be back to normal in May and that this time will be different.

Investors of this mindset will probably be using the events at the end of 2018 to justify this idea. Between early October and late December, US stock markets experienced a pronounced correction. Peak to trough the Nasdaq dropped by more than 23%. The S&P 500 and Dow Jones Industrial Average both fell just shy of that all-important 20% figure in the same period, which allowed investors to narrowly avoid designating the move a bear market. By the end of April 2019, they had all recovered and were trading above, at, or around their highs, respectively. A crisis had been averted and new all-time highs were in store. Maybe we’re about to witness a repeat of that, or perhaps it was just a dress rehearsal for a more significant move down.

Don’t try to catch falling knives

The ideas of buying dips and dollar-cost averaging – regardless of the underlying trend – have become prevalent in recent years. Many investors fail to recognise that these tried and tested strategies only work well in upward trending markets. Of course, the fact that pre-coronavirus the US was in the middle of the longest expansion in its history may have had something to do with this. The above strategies did exceedingly well over the last eleven or so years. Still, if this is the beginning of a bear market, dip-buying or averaging down are not to be recommended for all but the most aggressive of short-term traders. That is because, in a bear market, people regularly buy what they think is cheap, only to discover that it keeps getting cheaper.

On the other hand, as shown earlier, the larger the drops, the larger the potential bounces. During the GFC, bear market bounces of anywhere between 8-25% took place all the way from the highs in 2007 to the lows of 2009. Trading in volatile environments is risky; it’s easy to get caught out even when you’re trading in the right direction. That’s why if this is to be a prolonged downturn then holding some cash, or what traders like to refer to as “dry powder”, is recommended. Aside from the safe-haven play of precious metals or the perceived security of government debt, cash is king when the future is uncertain because it allows you to be in a position to make the right investments when the tide starts to turn.

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