Dow Jones 12266.39 -315.79 3:05 pm PST, March 2, 2008 NASDAQ 2271.48 -60.09 For info, visit access.smallcapnetwork.com S & P 500 1330.63 -37.05 Change your subscription status here Russell 2000 686.18 -19.54 VOLUME 08 : ISSUE 20 Bear Market Management (It's Not An Upside-Down Bull) Some day for stocks on Friday, huh? The market took it on the chin ...a dip of 2% or more for all the major indices. Had it not been for Friday, we would have ended the week with respectable gains. The question from here is simple - what's next for stocks in the shadow of Friday's strong selloff? There's no absolutely certain answer, but we've got some thoughts on the matter today. Above all else (and I don't want to come across as a fear monger) I do think we're in a bear market. Equally important is this ...I don't think it's a reason to abandon your trading activity. In my memory I've made as much money in a bearish environment as I have a bullish one. I've just had to adjust my strategies a little to do so.  Not that this is a complete list of things I'm starting to do, but here are a few things to think about just in case we go from bad to worse.    Go With The Flow In most of Bill O'Neil's books about his CANSLIM method he points out how 3 out of 4 stocks move the same direction as the market. Ergo, if we're truly in a bearish phase, the odds of successfully going long on a stock are about 1 in 4. You may indeed be holding that '1 in 4' stock, but that's a tough bet to make. Rather than look for the 25% of stocks able to buck the bigger trend, why not just profit from their declines? There are a handful of ways to do this now, and they don't necessarily require an advanced trading account. Starting with the easiest and moving to most complex, the key ways to profit from a falling market or stock are... 1) Go long with an inverse exchange-traded-fund (ETF). This just means you can buy an index ETF that goes up when the market goes down. If you can buy a stock, you can buy these ETFs in your account. ProShares and Rydex both offer these now, and there are others out there as well. If you wanted to improve your alpha a little more, you can also buy leveraged inverse ETFs, and even leveraged inversed sector ETFs. 2) Buy put options. If you're not a fan of options because you think they're risky, think again. They're different than stocks, but I don't think they're any riskier if you manage them the right way. Anyway, put options gain when the underlying stock or index falls (whereas a 'call' option increases in value when the underlying instrument rises).  3) Sell stocks short. I mention this possibility last because I think shorting stocks carries more risk than owning options. Theoretically the risk is unlimited with shorting stocks. Given the risk versus the relatively limited reward potential, I'm not a big fan of shorting stocks, though I know some of you have done well with it. As with any kind of investment, these bearish ideas have limitations and risks. Just be sure to understand your downside and upside first before doing any of them.  One of the things I've seen more than once is the overuse of leveraged ETFs. If 1/3 of your portfolio is long on a leveraged inverse ETF and the other 2/3 is invested directly in stocks, you basically have a wash - the gain on one negates the loss on the other. That's great, but obviously not a long-term solution.    Understand the Environment I can't count the number of times between March of 2000 and October of 2002 I heard the 'ultimate bottom' had been made....it was at least six, though only the last one was right (but even so, not confirmed until March of 2003).  It's not as if these people were off-base in their predictions - they were just trying to do something the market doesn't lend itself to ...which is being predictable. In almost all cases we saw a short-term bottom made at the time we heard the word 'capitulation'. And, stocks rallied sharply shortly afterwards. The problem was, stocks then proceeded to even lower lows. The flaw in their logic was this - a bear market is not an upside-down bull market. Bull markets tend to generate long, drawn-out uptrends. Bear markets are notorious for wild swing (both bullish and bearish), which can fake you out if you're applying strategies only effective in a bullish environment. I don't recall from where or whom I first heard this, but I completely agree with it...be an investor in a bull market, and a trader in a bear market. This mostly has to do with timeframes. You generally can't hold the bag too long in a bear market. Take profits when you have them, or you run the risk of the next bearish retreat.   Forget The News-Badgered Names If you think the media makes it tough to trade high-profile stocks in a bullish environment, wait until you see these stocks when things get ugly. I don't recall the last time I saw the thirty stocks in the Dow Jones Industrial Average trade this inconsistently, and these are some of the biggest and allegedly the best names we've got to choose from. Though not by a lot, the mid-caps have actually been the top U.S. performers since the beginning of the year. You know what though? Foreign stocks have been even stronger performers. Canada and most Latin American markets have easily topped U.S. stocks over the last couple of months, and they could continue to do so indefinitely. Regardless, I'm seeing some interesting charts pop up from a lot of U.S. names I'm not familiar with. Many of them seem to be from the Russell 2000 index, or maybe even smaller than that. Is this a potential conflict with suggestion #1 'Go With The Flow'? On the surface it may seem like it is, but I don't think it is in the grand scheme of things.  The 1 out of 4 stocks that will survive and even thrive in a bear market have to come from somewhere. Don't be stubborn about it, but if you think you've found one, then you think you've found one. By studying market cap and sector performance (birds of a feather flock together), you have a much better shot at finding the rare winner in bear market.   Epilogue Some final thoughts for today (though we've only scratched the surface)... Many of you have asked why I think we're in a bear market. My rationale is very simple - results. You know the 200 day moving average line I often plot on our market index charts? I use it because it's an inarguable indicator of long-term results.  Well, not only are all the indices under their 200 day lines, but the 200 day moving average lines are falling - sharply. We've seen this happen a couple of times between 2003 and now, but never this badly (or for this long).  Bear in mind this still leaves room for upside swings, like we discussed in part 2 today, 'Understand The Environment'. In fact, you may be surprised to know the market produces more huge single-day rallies and short-term bullish swings in a bear market than it does in a bull market. Don't get married to one of those moves ...it'll probably be short-lived. I think if we even get to retest the 200 day lines I'd use it as an exit point for longs, and an entry point for shorts. Others of you have asked how will we know when the market is primed to make one of its many reversals during a bear market? I'll refer you back to one of my favorite tools - the ISE Sentiment Index. The ISE index is a contrarian tool, meaning when traders are most fearful it's time to buy, and when they're most confident it's time to sell. The strategy seems to work even better in a bear market, since emotions are already intense. The nearby chart explains why I like this tool. Is it perfect? No, but it's a great way to get a feel for when the buyers or sellers are reaching their short-term limits. The plunges in the ISE Sentiment reading usually occur a couple of days before the bottom is actually made, though the tops for the ISE reading and the market tend to occur simultaneously. Based on the current chart, I don't really think we're at a trade-worthy short-term bottom yet, but I know we don't have enough optimism to start thinking we're at a major top.  By the way, my other favorite way to spot short-term tops and bottoms in any environment is though Fibonacci retracement levels. In the near-term (several days) I'm looking for more selling. In the intermediate-term (weeks) I think we'll see a pretty strong recovery rally...and perhaps a retest of the 200 day lines. In the long-term (months), like I said, I believe we're in a bear market. OK, now that we've opened up several cans of worms, we're looking forward to closing them in upcoming editions. Be sure to check out the blog often as well...we can add more details there than we can in the average edition of the newsletter.      We Value Your Feedback   Got comments, questions or suggestions? 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