A bull or bear market?
Jeff Clark - Thu 29 Jun, 2006
...A bull or bear market...In order to successfully weather a bear market, investors have to adopt a trader's mentality...
- In a bear market there's no such thing as a long-term hold. Typical activity in a bear market consists of day after day of tedious "nickel-and-dime" type declines, followed by blistering one- or two-day rallies, followed again by a series of tedious declines.
- Indeed it seems the purpose of a bear market is to not only punish the bulls, but also to extract a pound of flesh from the bears who hang around too long.
- In order to successfully weather a bear market, investors have to adopt a trader's mentality. That means shorting stocks as they run into resistance after the one-day-wonder rallies – and then diligently taking profits on those short positions as prices decline into obvious support zones. Too often I've seen bearish investors, worried that the market will cascade lower without them on board, put on maximum bearish bets at precisely the wrong time.
- Inevitably what happens is that the market puts on one of those remarkable bear-market rallies and the overexposed bears end up having to buy back their short positions at a loss.
A bull or bear market: When the bulls controlled the market
- Keep in mind it was only a few short weeks ago that bulls firmly controlled the market. We saw higher stock prices nearly every day for two weeks, and the relentless day-after-day climb toward new all-time highs caused hesitant investors to finally capitulate and buy at the worst possible time.- Today, it's the underexposed bears that are feeling pressure to leverage into position. But that's a mistake. Just as buying stocks into the relentless rally several weeks ago proved to be a big mistake, investors who short stocks into this relentless decline will suffer a similar fate.
- There's a rally coming – I can promise you that. It's simply a question of when.
- By far, the most successful strategy for trading a bear market is to wait patiently for the inevitable one-day-wonder rally that catches all the bears leaning in the wrong direction. Then, as prices rally strongly up toward clearly defined resistance lines, establish the appropriate short positions.
- I'm not saying that we've officially entered a bear market. In fact, as you'll see in a moment, the jury is still out on that issue. But the bull is on borrowed time, and it'll pay to know the proper way to welcome the bear.
A bull or bear market: The 'line in the sand'
- The 65-week exponential moving average is widely considered to be the "line in the sand" separating bull markets from bear markets.- Stocks that trend above the line are in bull markets and the moving average serves as the last level of support. Stocks that trend below the line are in bear markets and the average serves as resistance.
- The S&P 500 touched a very critical level a few days ago, when it pierced through the 65-week average at the 1240-level. But the market bounced back above this level, and even after yesterday's sell-off, sits at 1,242.
- The direction of the market over the next few days will tell us whether the bull is still running, or whether the bear is awakening from a three-year hibernation.
- If the bull market is alive and well, then we should see an almost immediate move upward. That type of action would be consistent with the three previous occasions that the S&P 500 sliced into its 65-week moving average.
- On the other hand, if the bear is now in control, then stock prices should quickly slice through this support line and decline perhaps as low as 1175. But even in this case, stock prices should rebound and come back to "kiss" the line from below before resuming their decline. Indeed, that is exactly what happened when the bear market began in October 2000.
- For the moment, it looks to me like the low-risk trading opportunity is to approach the market from the buy side and to bet on a significant bounce – if only to relieve the extremely oversold conditions. But I've held that opinion for most of the past week or two, and all that we've seen is every single rally attempt get hit with more and more pervasive selling.
A bull or bear market: Current conditions
- Nonetheless, given the excessive pessimism among investors, the extreme oversold conditions of numerous technical indicators, and seasonal tendency for a summer rally, it's a mistake to bet too heavily on the short side just yet.- Remember, bear market rallies are violent and explosive. Current market conditions are extremely oversold and susceptible to a strong seasonal bounce. So investors should be very careful about initiating new short positions at current levels.
- The S&P 500 could very easily rally back up to "kiss" its 50-day moving average at about the 1290 level. That would give us a good low-risk entry point to re-establish broad market short sales.
- Until then, however, it's best to keep our powder dry, except for very specific low-risk short-sale opportunities.
Regards,
Jeff Clark
for The Daily Reckoning
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