Have you noticed that in the midst of this heated presidential campaign the candidates never talk about the financial markets? They occasionally make a reference or two about the economy but Wall Street and the major stock indices never get a mention. I suppose that is because it is difficult for them to take credit when the markets move up and they certainly don’t want to take the blame when the markets move down.

This week the indices have continued to struggle, even with a better than anticipated GDP number and with lower oil prices. There is no immediate end in sight to the downturn that began in October and investors need to remain defensive.

Below is a chart showing the S&P 500 over the past three years. I’ve highlighted a couple of aspects of the chart to better illustrate the current situation. First I added a red trendline to show the general slope of this bear market. This shows that since October 2007, the S&P 500 has lost about 300 points or about 20%. But if the same slope and duration persists, the damage will be more severe. From this point another 300 points lower would be an additional 24% loss.

I’ve highlighted the steepest drawdowns with blue arrows. One common question from clients is why we do not take more short positions during bear markets to try to make money on the downside. Notice the steepness and severity of these drawdowns. Often the bulk of the damage occurs in just three or four days. Our trading strategies are based on mathematical models. Experience has shown that if we apply too tight a trigger to the models, investors get whipsawed in and out of trades and it is difficult to capture gains.

Sometimes we do use short funds but it is usually part of a risk management strategy rather than an attempt to create profits. For example, one strategy has held a position in Prudent Bear fund (BEARX) for several months. That position is being used to hedge the risk of offsetting long positions.

The gold line on the top portion of the chart is a 50-day simple moving average (MA) of the S&P 500. Currently the index is holding right at that line. Since October, the only two months it has been above its 50-day MA were April and May. While we could see it bounce above that line again here, the market does not seem to have enough momentum to reverse the overall bear trend.

Finally, the bottom portion of the chart is a moving average convergence divergence (MACD) of the S&P 500. It is showing that the slight upward move of the past few weeks is already faltering. Any significant economic news could send the index plunging on another of those steep downward spikes.

For the near future, staying on the sidelines remains the safest place for investors.
   
F.S.

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Early this spring I acquired 18 baby chicks and began the process of raising them to become fully fledged, egg-laying chickens–a process that normally takes about six months. I have had chickens before, so I knew there would be some casualties along the way. Prior chickens succumbed to neighbor’s dogs, drowning in horse troughs, and being so ornery that they became more appealing as soup than as egg producers.

I figured that if even half made it to adulthood, this fall I would have an abundant source of free-range chicken eggs. In the past with just three or four chickens it seemed like there were always more eggs than we could use.

I never counted on the fox. I live in an urban area where foxes are relatively uncommon. But it only takes one and this one has killed as many as five chickens in a single night. I am now down to two hens and one rooster. I’ll be lucky to have enough eggs to make pancakes for breakfast, let alone enough for scrambled eggs.

So far my efforts to hasten the fox’s entrance into the afterlife have been unsuccessful. But I am holding out hope that the remaining three chickens will survive because they have learned to fly into the barn rafters when the fox makes an appearance.

At some point I realized this experience has many parallels with what investors experience during bear markets.

When investors first put money into the markets, it is only natural that they start anticipating the gains they will make in the near future. If they happen to invest at the right time in a bull market, the money seems to grow quickly. But if their investment is followed by a bear market, they money they invest immediately starts to diminish.

As the account value declines, the reaction from investors is to assume that there is a serious problem. After all, the whole point of investing is to see one’s money grow. Unfortunately, bear markets are as much a part of the economic cycle as bull markets.

Like the fox that is killing my chickens, bear markets give their victims a sense of helplessness. There simply is no way to quickly and easily resolve the problem. Although there are several actions one can take, there is no assurance that any of them will work.

I started by trying to make sure my chickens were safe in their coop at night. But one night the fox figured out a way into the coop. Trapped inside with the fox, the chickens were easy pickings.

I have set traps for the fox, but so far he has not been cooperative about entering.

I have a shotgun by the back door, but the one time I saw him carrying off a chicken he was out of range.

I am now resigned to the fact that survival of the last three chickens is pretty much up to them and out of my control.

An investor trapped in a bear market can try to find an investment that is inversely correlated. During the 2000-2002 bear market many investors moved assets out of the financial markets and into real estate. While a few got lucky, it hasn’t worked out very well for many others. Right now it is very difficult to find any sector of the economy that is advancing. Chasing short-term moves in an attempt to make money often results in investors being caught in moves Wall Street calls “bear traps.”

Those who espouse a buy-and-hold approach would have investors stay in the market and ride out the downturn. There argument is that things will eventually improve and the market will bounce back. Unfortunately that is not a realistic option for investors who are retired or who are near retirement.

Some try to make money in a down market by shorting. In other words, they make a bet that the downturn will continue. But it is a risky gamble and really only suitable for very aggressive investors who can withstand significant losses if the market turns up quickly.

Although it is difficult to accept, during a bear market investors need to stop thinking “how can I make money?” and start thinking “how can I avoid losing money?”

During most bear markets the very best course of action is to move to the sidelines and wait for a new upward trend. By their nature, financial markets are cyclical and bear markets will always be followed by bull markets. That raises the obvious question: When can I get more chickens?

Unless the fox ends up in a trap or within range of the shotgun, buying more chickens right now would seem to be less than prudent.

Perhaps you were thinking of the other question: How does one know when it is safe to move back into the market?

That is when it helps to have a thorough understanding of fundamental and technical analysis. Or if you use the services of a professional money manager, that is why it might be worth paying a management fee even when your account is just sitting in a money market fund.
F.S.

With more than seven months of the year now behind us, it is interesting to take a look back and see how things stack up so far. One of the best ways to do that is to look at various market and industry sectors. There are currently more than 800 exchange-traded funds (ETFs), representing virtually every sector or index. So what are these funds telling us?

Of 806 funds tracked by Yahoo!, 148 have positive returns for the year so far. That means 82% of all ETFs are negative.

Breaking down that 148, 52 are energy or natural resource funds. Returns from that group range from less than 1% to 73.7%. The highest return was posted by United States Natural Gas Fund (UNG). Another 35 are bear market or short funds. In that group returns ranged from 3% up to 57%.

Unfortunately, gains are only half the story. Most investors have not participated in these profits because these funds are generally much too volatile. For example, although UNG is showing a nice gain for the year, it has fallen 42% in the past six weeks. Based on trading volume, many investors bought in near the price peak and have lost significant money since then.

Below is a list of the remaining 60 ETFs and their year-to-date gains. You’ll see that it is quite a diversified list including precious metals funds, currency funds, and even municipal bond funds. Most of these funds carry high risk. So while it is easy to look at the gains and wish we had those in our accounts, just keep in mind that for every two of these funds that show a profit, there are eight others that have suffered losses in 2008.

So what does all this mean? Not much, other than what we already know: so far it has been very difficult to make money in the markets in 2008. Perhaps more important, so far it has been very easy too lose money–in some cases a lot of money–in 2008. So if you are looking at your statements and seeing single-digit losses for the year, you can take heart in knowing that you are probably better off than the majority of investors.

Summer is quickly coming to an end. My wife is a school teacher and she has been working for two weeks already in preparation for the school year. Children in her district will be in class on Monday.

The good news is that the end of summer often is good for the markets. People come back from vacation, Congress goes back into session, and Americans resume a more normal pattern of living and spending. Enjoy the last of your summer and hope for better investment conditions in the coming weeks.

F.S.

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The way the markets have performed over the past several months, it is easy to become discouraged and to believe that the situation is going to get much worse. But investors should always remember that no one has ever been able to predict market behavior with 100% accuracy. And the financial markets have a way of surprising even the experts by doing things that have not occurred in the past.

While the picture remains gloomy for now, there are a number of reasons that investors should start preparing for the end of this downturn. For example, the U.S. Department of Labor reported that unemployment jumped 0.5% in May 2008. In the past 50 years, this is only the 12th time that the jobless rate has jumped that much in a single month. The previous 11 times, in the 12 months following the S&P 500 has risen by at least 17.6% and the average gain was 26.8%.

The Wall Street Journal reported that earnings per share of the S&P 500 companies in the second quarter of 2008 are expected to be 18% below the same quarter in 2007. It will mark the fourth consecutive quarter of smaller profits. The all-time record for declining earnings is five straight quarters.

The current bear market is the 14th to occur since 1950. The average duration of the previous 13 bear markets is about 15 months. The current bear market began in October 2007. It will reach that 15-month mark about the end of the year.

One can argue that the circumstances surrounding this bear market are very serious and could prolong its impact. But the truth is that the situations that create any bear market are grave and unusual. The bear market that began in 2000 was already a year old when terrorists brought down the World Trade Center. That event deepened and extended the bear market to one of the worst in the history of the financial markets. The current situation is not nearly as dire.

Below is a chart of the S&P 500 over the past decade. One can easily see the severity of the 2000-2002 bear market. But you can also see the bear market we are now enduring is no slouch. The bottom portion of the chart is a moving average convergence divergence and it shows that we have not seen this kind of volatility for more than five years. 

Of course just because we think the end of this bear is in sight does not mean anyone can pinpoint the exact bottom. As an investor I’d be a little cautious about jumping back into the market at this point. On the other hand, now is undoubtedly a better time than last October!

I can’t tell you what the catalyst will be that will start the next bull market. It could happen when the price of oil drops below $100 a barrel. It could be the presidential election. So while it is easy to be discouraged right now and to start to believe that this will never end, take heart. That usually means the bottom is right around the corner.
F.S.

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