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Anatomy of a Bear Market


Richard Suvak, MSF, CFA


We all know what a bear market looks like after the fact.  Along with the loss of wealth, there’s pain, confusion, despair, self-doubt and a commitment to take risk more seriously next time.  While Hindsight Capital LLC has amazing returns only a clairvoyant could achieve, there are clues present which could help us decide our investment strategy.  And, while history was never my favorite subject (I can never remember dates… just ask my wife), history can be helpful in understanding where we are now.  To that end, I’ve compared the recent market peak of January 26, 2018 to prior market peaks, both known to be the start of a bear market and those which were just a mid-point in the continuation of a bull market.

For better or worse, this work will not involve a great deal of statistics.  In fact, it delves into the dark art of technical analysis – one which I admittedly have very little regard.  You may ask, then why do it?  The reason is simple; technical anlaysis, I believe, is the most used analysis method today.  For some reason, again my opinion, people have turned to reading charts as their key analysis tool when making investment decisions.  They draw lines of support, lines of resistance, bear-market wedges, bull-market wedges, Elliott waves and a multitude of other shapes on historic market charts to support theories about future market direction.  Apparently, and using the same chart, there are an unlimited number of conclusions which can be drawn from the use of a simple line connecting a few dots.

However, while I scoff at the theories and logic, the fact is that the more people use such approaches, the more valid they become.  For example, if everyone believes that a stock has support at $10 and is willing to buy the stock when it hits that price, then the theory will hold.  It’s a self-fulfilling logic with no logical basis other than group-think (again, my opinion).

But it is here that this paper makes a bit of sense.  That is, if more and more investors are turning to technical analysis, then more and more of the market’s movements are technically related.  It has been my theory for some time that the markets are not following the underlying fundamentals.  Rather, they seem to be more momentum related and less risk averse.  Buy the dip, and the more profane BTFD! are common phrases of investors these days.  We’ve seen what this looks like in a purely technical market with no fundamentals.  Once Bitcoin became known and investing became easier and a few stories of quick riches were told, it took off.  It ran for the same reason as the gold rush or the tulip-mania.  It ran because it was running.  When it crashed, it found a footing (for no apparent reason) and ran again.  It is my belief that the current stock market has been showing signs of doing the same.  All bad news is ignored.  Valuations are ignored.  Unrealistic growth expectations are ignored.  It goes up because it has been going up.  If it falls, it finds a footing and goes up again.  Until it stops going up.

Therefore, the question is; was the peak in January a temporary peak along the path to a higher high (a common technical analysis phrase), or was it a change in direction?

Shape of History

The above chart shows market returns 252 days prior and 252 days after all non-bear market peaks (truth be told, each line is represents the yearly average of market peaks – there was too much data to plot each peak individually).  The wide, dark gray line is the average of all non-bear market peaks.  As you can see, most market peaks are simply a weigh-point to more gains.

The chart below however tells a different story.  Granted, this shows all known (using hindsight) bear-markets in order to show the different trajectories.  As you would expect (due to hindsight), bear markets are bad.  A peak in this case is in fact a peak.

Viewing bear market returns another way shows the impact different holding periods have.  Again, the run-up to a market peak is very attractive.  Yearly gains are a minimum of 10% and often achieve 20%.  Even 10 days prior to a peak, the market is still posting solid gains.  However, once the bough breaks, it’s all bad news as everything turns red and previous gains are erased (remember, 20% losses are greater when following 20% gains – $100 x 20%=$20 but $120 x -20%=-$24).

So, what does today’s market look like?  Superimposing the current market with the average bear market and average non-bear market peaks provides the following.  Giving way to technical analysis so that we can compare the shape of the different markets leads to only one conclusion – we look more like the former than we do the latter.

Combining the three in a bar chart shows the same.  Leading up to a market peak, future bear markets look similar to continuations of bull markets.  However, once the peak is reached, their paths diverge.  As things stand now, we are following the bear market path and not the continuation path.

What’s the Trigger?

When then do investors concede the future returns of the stock market are unlikely to mimic returns of the past?  When will the big Wall Street banks warn their customers of the risks this market represents?  When will the gold rush end?  Unfortunately, we’ll never know for sure until we’re able to look back and see.  Perhaps it already has.