How To Position In Bear Markets

A successful self trader – Rule # 33

There are actually two parts to this rule. Firstly, how do you identify a bear market from a temporary blip? Secondly, how do you make the best of a bear market? Both are easier said than done. But there are some basic characteristics of a bear market like reversal of leaders, lower lows and consistent negative breadth. But the question is; how to weather a bear market and also make the best of this difficult phase?

Make the best of bear markets

How exactly do you define a bear market? The most popular measure of a bear market is a 20% correction from the peak. Some analysts also define a bear market in terms of 3 months of consistent negative returns in the market. But in a way, bear markets are like the elusive temptress. They may be hard to define and delineate, but you can surely recognize one when you see them.

Bear markets have at times been unique to countries and at times global. Typically, a sharp correction in oil prices led to bear markets in countries like Russia, Brazil and the Middle East. The tech-driven bear market was a global phenomenon. The 2008 bear market was a problem unique to the US, but due to inter-connected market systems, the tremors were felt across the world.

The important question is how do you identify and make the best of a bear market? Most investment strategies, the world over, are on the long side. Hence a bear market tends to systematically impact the vast majority. Once a bear market is identified, the next challenge is to lay out the measures and strategy to mitigate the impact of the bear market and strike while the iron is hot. But, how exactly do you do that?

3 classic signals of a bear market

 Look out for the 3-step process

The best way to identify a bear market is to carve out the 3 phases. The sharp crash is followed by a sharp bounce back. Then volatility dies down and the market gradually grinds down. This is the classic bear market.

 Liquidity and leadership hold the key

A bear market is created if the liquidity driving the bubble suddenly dries up. Watch out for rate hikes and controls. Also check if the leaders who caused the bull market are seeing consistent value destruction. This is unmistakable!

 Consistent negative breadth is a classic give-away

Negative breadth is created when the declining stocks consistently outnumber the rising stocks. This trend is visible in large caps and mid caps. Coupled with illiquidity and loss of leadership, breadth defines the perfect bear market.

“If you buy stocks wisely in a bear market, then at some point in the future you will be happy. But, you need to act” – Peter Lynch

6 Rules of Trading and Managing a Bear Market

  1. In a bear market, traders must sell on rises; not buy on dips. That is the underlying nature of the market and you are not going to gain by trying to outguess the market. In a bear market, rising prices tire easily and the overhang of supply will invariably create weakness in stocks and indices.
  1. Play the options game in a bear market very carefully. Call options may appear to be cheap, but they may actually be worthless. Put options may appear to be liquid and attractive but they tend to be overpriced in a bear market. A bear market creates many option pricing and value mirages. Be careful of them. 
  1. If the leaders of the bull rally made money for you, it is still time to dump them. Don’t get emotional about stocks that stood you in good stead during the Bull Run. They are not relevant any longer. In fact, they are the ones that caused this bear market. And similar bull markets rarely repeat. Just run for the exit. 
  1. Remember, losses are tax-efficient too! If you are sitting on book losses on stocks, don’t wait in the hope of a bounce-back. Book the loss. You can either adjust against other profits or carry forward these losses. In a worst case scenario, you will be able to at least extract the 33% tax rebate on these losses. 
  1. You cannot control a bear market but you can surely control what you do. Ensure that you don’t leverage too much. Try selling higher calls to reduce your cost of holding stocks. Restructure your portfolio. Shift out of cyclical stocks and high beta stocks and swap them with defensives. 
  1. Last but not the least, a bear market is also the time to extract some excellent bargains. Rewind yourself to 2002 and try to examine the price of capital goods stocks. Had you accumulated in 2002, you would have had a multi-bagger portfolio by 2007. Same was the case at the nadir of 2009. But you need patience!

How to position your self in a bear market

The most important challenge in a bear market is to be liquid when the opportunities arise. Most investors, I recollect, were so outraged and demoralized by the tech crash of 2000 that they stayed out of equities as an asset class. That is the wrong approach. Singed by 2000, you cannot miss the Bull Run from 2002 and burnt by 2008, you cannot miss the Bull Run from 2009. There is nothing like a point of no-return in equity markets. 

The most important challenge in a bear market is to identify one. During the market rally between 2003 and 2008, there was a serious 35% correction in 2004 and a sharp 31% correction in 2006. But these corrections were not accompanied by other bear market indicators like ceding of leadership, tightness of liquidity, negative breadth of the market etc. Not surprisingly, the markets bounced back. Since 2009, every correction has resulted in a stronger bull rally. Yes, again, the bear signals are absent.

Takeaways from The “Bear Market” Debate

The legendary Sir John Templeton famously said, “Bull markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria”. The converse applies in case of bear markets. The point at which everybody predicts the end of equities as an asset class and despondence rules the market, you can be sure that the bear market is approaching its end. If you are a long term investor, this is the time for you to start getting out your shopping baskets and do some bargain hunting. 

Always remember one thing about bear markets. As much as it is easy to predict bear markets, it is extremely difficult to act rationally in the midst of a bear market. A bear market tests your patience, endurance and conviction to the hilt. Remember, a bear market is accompanied by a crisis of liquidity, confidence and solvency. Surviving through a bear market itself is hard. Trying to hunt for bargains with conviction is an uphill task. For an investor, that could be the real Baptism by Fire!

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