Trading in a bear market

The rout in equities over the past few months has seen many indices either move or fall further into a ‘bear market’. While it is not easy to define such an event, at least until it is over, the standard definition is that such a market takes place once stocks have fallen 20% from their previous high.

These often accompany recessions, but not always, and this is a key part of the current debate, namely whether the current weakness in equities presages a more sustained downturn in the global economy or whether it is merely a reaction to the strong run of performance seen in US equities since the last presidential election.

In a bear market, prices tend to fall. But it is important to remember that prices do not move in straight lines. As traders, our job is to pick our moment to enter trades carefully, ensuring that risk management is employed to ensure that potential losses are kept to a minimum.

It is rarely as simple as pressing the ‘sell’ button and allowing the trade to take care of itself. Those looking to go with the trend and take short positions are, for the duration of the bear market, likely to enjoy successful trades, but it is important to pick their moment. The chart below shows the S&P 500 from mid-2007 until mid-2010.

The index dropped below the 200-day simple moving average (SMA) towards the end of 2007 and continued to decline until April 2009. While overall it dropped from around 1500 to a low near 600, it was not a straight-line move.

Over the period, there were several intense rallies, gaining 15%, 9.5%, 27% and a remarkable 40%, with the last marking the beginnings of the post-2009 bull market.

Thus, those looking to take the short side should be aware that the potential for sudden rebounds exists. Indeed, since most investors are ‘long-only’, there will be plenty of buying into weakness as investors look to pick up bargains. This can develop into the kind of rallies we saw in 2008.

US markets are only just on the cusp of a bear market, but others have been falling for over six months. To take a popular market, the DAX hit an all-time high in January 2018, but from May onwards a downtrend really kicked in.

The red rectangles mark lower highs, but preceding these were a number of rallies that saw the market surge an average of 5%. Each new lower high was a good selling opportunity, but it required timing, and the use of either an indicator like stochastics or moving average convergence divergence (MACD), or breadth such as the percentage of stocks in the index above the 20-day moving average.

Indeed, while in bull markets it rarely makes sense to stay short for any length of time, in bear markets there is far greater opportunity to buy the dips and then sell the rallies. It is rarely the case that the market simply falls each day. Rather, being judicious about short positions and also being open to the idea of going long when rallies develop can be a fruitful strategy.

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