MarketOwl is provided as a FREE service to clients and friends of Strategis Financial Group. If you have friends or family who would be interested in our market advice, please encourage them to subscribe.

Investors tend to be ruled by emotion. The predominant investor emotion is usually greed. The second most powerful emotion for many investors is fear. Ironically, even during a prolonged bear market like we are currently experiencing, investors who have experienced significant losses and who fear additional losses can be overcome by greed.

We can often see this phenomenon during bear market rallies. 

Investment markets have periods of upward movement, even during the most severe and prolonged bear markets. Sometimes these upward moves only last a day or two. Other times they can persist for several weeks or even months. The longer advances that occur during a long-term bear market are commonly referred to by investment professionals as “bear traps.”

The rallies earned this moniker because they lure investors back into the market hoping to recoup some of their losses. Unfortunately, at that point the downward trend resumes and investors get caught and suffer additional losses.

Below is a chart showing performance of the S&P 500 during the prior bear market that began in 2000 and continued through 2002. I’ve highlighted some of the rallies using green arrows and some of the downward moves with red arrows. You can clearly see that there was plenty of both up and downward volatility during this period, but the dominant trend was unquestionable down. From the peak in March 2000 until the bottom in October of 2002, this index lost about 48%.

 
From the chart you can tell that many of the downward moves are quite substantial. That is where the real danger comes from these bear market traps.  By trying to jump in and out of the market to take advantage of these short-term moves, it is possible that an investor with poor timing might actually lose more than the overall bear market drawdown of 48%. That is also the danger of using short funds in a bear market. By jumping in and out at the wrong times, it is possible to significantly compound the risk and the damage.

Now let’s look at a chart of our current bear market for comparison. Again I have shown the price movements of the S&P 500 and I have highlighted the up and down moves with arrows. From the peak in October 2007 until the most recent low, the index dropped about 55%. It is certainly possible that there could be additional losses going forward. Notice in this instance, the declines have been steeper and more severe and there have been very few rallies.

 
It is apparent that there have been few rallies of any substance during this corrective market. At Strategis, our trading strategies are not designed to take advantage of short-term market movements. This is an intentional strategy created to avoid whipsaw trades and instead take advantage of longer term trends. So the reality is that we will generally miss the early part of any upward or downward move.

Let’s consider a specific example. After bottoming in November 2008, the index rallied into the first week of the new year, gaining about 17% during that time. Our technical triggers came very close to signaling us to get back into the market at that time. Looking back, that obviously would have been a big mistake, because the S&P 500 has dropped sharply since then. Fortunately we stayed out and appeared to be very smart. 

Notice also that over the two bear market periods shown on the above charts, the potential gain for any given rally during a bear market is limited. We all want to make money and that urge can be especially strong after a significant market correction like we are experiencing. Investors who have lost money feel a powerful need to make up those losses. Even investors who have avoided the downturns get anxious because they know eventually a bull market will re-emerge and they want to squeeze as much profit as possible out of it. But these bear traps are times when market risk probably outweighs any potential reward.

This week we have again seen a few days of upward market movement. Is this the beginning of another bear trap, or is this the early stage of a trend reversal and a new bull market? Only time will tell us for sure. But our indicators continue to signal that this is not yet the time to jump back into the stock market.
F.S.

You requested this MarketOwl free e-newsletter. Please add support@marketowl.com to your e-mail address book to ensure prompt delivery.