Who's Afraid of the Big Bad Bear?

Posted by: Ben Steverman on July 8, 2008

Stocks are just barely in an official bear market, a condition described as a 20% decline from the recent high. As I type this — on the morning of July 8 — the S&P 500 is 19.96% off its Oct. 9th high and the Dow Jones Industrial Average is down 20.5%.

The bear market designation is arbitrary, but it’s not meaningless. Investors, and especially traders, have been trained to act differently in a bear market.

For an example, I pulled off the shelf “How to Make Money in Stocks,” the bible of William J. O’Neil, the founder of Investor’s Business Daily (where I previously worked). William O’Neil is the anti-Warren Buffett in that he eschews buy and hold strategies. With just a glance at fundamentals, O’Neil picks stocks mostly based on technical factors, especially by watching the shape of a stock’s movements on a chart. It’s sometimes called momentum investing, but I know O’Neil doesn’t like that term.

For traders like O’Neil and his disciples, it’s relatively easy to make money in a bull market buying and selling stocks. In a bear market, it’s the reverse: No matter what trading methodology you use, it gets “very frustrating,” Avalon Partners chief market economist Peter Cardillo told me yesterday. Because most stocks keep sliding downhill, “Very little works.”

O’Neil writes: “In the final analysis, there are only two things you can really do when a new bear market begins: sell and get out or go short. When you get out, you should stay out until the bear market is over.”

But how can you tell when a bear market is over? Or when it’s starting? “The typical bear market (and some aren’t typical) usually has three separate phases, or legs, of decline interrupted by a couple of rallies that last just long enough to convince investors to begin buying,” O’Neil writes.

In other words, a bear market is full of head fakes and false signals. Just as it looks like it’s getting better, stocks fall again. Just as the mood is gloomiest, stocks start to recover. Sometimes bear markets are quick and relatively painless; sometimes they drag on for a couple years or an entire decade.

This is the most confusing part of O’Neil’s system (and it’s the same flaw in any trading system that’s not long term): O’Neil provides no easy guidelines for when to jump back in the market, and he admits that he’s made mistakes buying back too early.

Bear markets are tricky terrain for investors. This may not be the wisest move for long-term investors, but it’s easy to understand why some prefer to simply wait it on the sidelines by putting everything in cash.

Reader Comments

M Wildes

July 8, 2008 2:44 PM

Can you please explain to me why there are people making money selling and buying stocks, why is day trading a real job? To me a job is a growing food, building something, making a product or providing a service that is needed by the average American consumer. How can people consider themselves to be safe when there livelihood could be sold at anytime. Traders are not in this to serve anyone only to make the almighty buck with no regard for the people that work for the companies they are playing with. What will we do when our 401K’s are worthless! The people that day trade are NOT investors they have invented a job that benefits only themselves. We all should take a hard look at the people that have real jobs and work hard each day. The housing market was extinguished by companies that built to turn over the property not live in the homes. Our jobs are going away along with there homes. The middle class is now poor and the rich keep getting richer. When will the madness stop?

Aaron Martin-Colby

July 8, 2008 4:17 PM

@ M Wildes: Don't we all do things for the almighty dollar? Traders give the market liquidity. If they didn't exist, now that's when companies would be screwed.

They are not the ones who hurt companies, or ruin 401k's, or crumple the economy.

Trading is a zero-sum game. They gain and lose money from each other, that's it. It has little effect on the company aside from giving us a roller-coaster ride to market determination of a company's worth.

I understand your frustration with a wild economy, but day traders are not the issue. Over-exposure to debt is the issue, and that's everyone's fault.

Private Banker

July 8, 2008 4:23 PM

I agree with the author. However notwithstanding the failure of technical analysis to predict markets in negative market conditions, fundamentalists have not succeeded either. This is evident with the demise of many large financial institutions who are known to take prudent investment decisions. Market take new dimensions every day. A target of 20% fall to be an evidence of a bear market, might no longer be applicable. Having said that, it will really take something very very big to pull up the markets from these levels. And with US being tracked as one of major markets, majors like Mr Bernanke and Mr Paulson will really have to think harder to tackle the situation.

Rag

July 8, 2008 4:51 PM

@Wildes: Think of traders as cleaners and plumbers of the financial system that keeps this country and economy clean and working, else there would be rationing for food and everything else.

Helen McGinn

July 8, 2008 6:52 PM

Traders have been around since economies began i.e. when groups of people organised themselves into hierarchical, evolving teams with leaders, law and order. Traders keep business going; they ensure honesty amongst many other things.

We've just felt the bear's claw over here in the UK and the depression (with a small d) has started; no more talking about equity, home improvements and holidays, in fact, even Christmas is being viewed with scepticism...in July!

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About

Bloomberg Businessweek’s Ben Steverman focuses on the latest moves in financial markets and emerging trends in stocks, bonds, and funds, always with an eye toward giving readers a better understanding of the sometimes confusing and often chaotic world of money. Standard & Poor’s senior index analyst Howard Silverblatt will also provide his take on companies’ finances and the markets. Voted one of the “Top 100 Finance Blogs” in 2007.

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