In part 1 we said that we could evaluate whether a Market was a Bull or Bear depending on the:
Now we’re getting to the real meat of the matter – Price Action. How can the price tip us off that we’ve entered a Bear Market? , we’ll reveal some of the usual technical signals associated with the warning of an impending Bear…..or the confirmation that we’re in one. Â
We all know as traders that a downtrend is defined in Dow Theory as a “series of lower highs and lower lows.” But WHICH highs? Which lows? What timeframe?
A Bear Market doesn’t truly begin until we see a “lower high” on the Monthly chart, preceded by a deep “lower low.”
And, of course, that “lower low” was more than likely the “shot over the bow” that we discussed in part 3. Far too many traders try to hop onto the Bear Market way too early, before the initial move has proved that it’s anything more than a correction. When the Bear truly does come, the trap door will open and there is no refuge. Let’s show an example of this from the last Bear, which started near the end of 2007.Â
The initial “shot over the bow” came in July of 2007; on the daily chart this created a series of lower highs and lower lows, and the move lower “took out” the prior intermediate low:
You can see that those who were early jumping onto the Bear Market were surprised beyond belief that the price went to new highs! In fact, this is a very common pattern going back over a hundred years….Bull Markets die very reluctantly. So…maybe if we stretch our timeframe out to the Weekly chart we can avoid those initial wiggles? Let’s see the same time period on the Weekly chart:
Now we’re getting somewhere. Sure, at the time, it feels as though the entire Bear Market is slipping away without you, but in reality if you waited for the Weekly Lower High to form, it was less than 150 points from the previous major swing high. If we take one more step back from the daily fray, we can see that the Monthly chart actually shows the cleanest read on the price action, with a well-defined “lower low” followed by a failure at the “lower high”.
At that point, the route is on and you were able to save yourself from all the uncertainty and chop that preceded it, which took the better part of a year to play out. It can sometimes take a long time to turn the Bull Market “battleship” around, but when the necessary groundwork is done to turn the larger-timeframe charts, the fall can be very swift. On the left side of this chart, you can also see how the 2000-2002 Bear market played out; it also showed the same heavy volatility before it finally gave way to gravity.Â
I think what we’ve shown through this four part series of articles is that the initial move that we’ve seen in July/August 2011 mirrors many of the characteristics that we’ve identified as the opening salvo in a Bear Market. We have everything in place except for the Relief Rally and the final “lower high” setting up on the Weekly and Monthly charts. Perhaps this time will be different and prices will just drop off the cliff from the May 2011 highs without bothering to set up that final lower high, but I haven’t seen any examples of this occurring in the past. In addition, the Federal Reserve is going to keep interest rates extremely low for the next two years so it’s very likely that investors will not have any place else to park their capital but “bargain” equities that have been distressed by this summer 2011 opening salvo to the downside.Â
So no, it’s not a Bear Market just yet, but it has the potential to quickly turn into a very nasty one.Â
The first thing that you can do is to study the Bear because you’ll have some time to prepare after the initial “shot over the bow” comes to pass. It will be accompanied by gloom and doom and a feeling like the “end of the world” is upon us, especially if you make your living from the market. What will come next will surprise most people not familiar with how Markets move, as the relief rally will wipe out all those shorting at the bottom of the initial move. Sometimes this relief rally will lead to new highs, sometimes not. In any case, if history is any guide, you will have several months in which to get your affairs in order.Â
First off, if you are heavily long Stocks or other assets, you can look to distribute your inventory into the relief rally and lighten up your long exposure, perhaps even starting to scale into some inverse funds. Those who are adept traders can play the initial relief rally as an opportunity, as there will be plenty of quality issues at a deep discount……but look to unload them during the rally when the news is the sunniest. The top of the relief rally will be accompanied by the typical Euphoria and the feeling that “we dodged a bullet this time!” but it’s definitely a time to be light and nimble and not overweight long. The Relief Rally will eventually crumble in a fractal pattern, starting with intraday charts and then setting up a “lower high” followed by a “lower low” on the daily chart, which will then lead to the same on the Weekly and eventually the Monthly charts. The cascade becomes an avalanche when the Bear truly kicks in.Â
If you are an Options trader, you have many more avenues open to you to trade the Bear; you don’t have to run to cash like most of the Stock players. In the next series of articles I’ll illustrate how to play the Bear a little differently using Options.Â
Doc Severson