Do You want to Ride Through another Bear Market?

by Macrotides

Editor’s note: The market timing methodology described is proprietary.  We are sharing the results Macrotides has published as a demonstration of a risk control process that has a good track record.  Readers are encouraged to become students of the markets and make sure they determine what risk control process might be best for them.  To contact Macrotides, use the e-mail address in the About the Author section at the end of the article.

My technical work and fundamental analysis suggests a bear market began in early August.

First, let’s review how a number of large well known mutual funds performed during the bear market declines of 2000-2003 and 2008-2009.  These funds were all rated by Morning Star with 4 and 5 stars. The S&P 500 lost -12.02% in 2001, gave up -22.15% in 2002, and plunged by -37.02% in 2008.  The performance of the funds we will show shortly during these bear market years reaffirms that most stocks trend with the overall market, and are thus vulnerable to market risk.

Traditional asset allocation relies on diversification to manage market risk.  The results during these bear markets shows it does a poor job, at least for the examples shown.

Investment Strategy During a Bear Market

Most investors remain invested during a bear market because their advisor or financial planner does not have the tools needed to navigate the market swings that often occur in a bear market.  We have done extensive research in how to manage the volatility associated with bear markets.  Our investment program’s primary focus is preservation of capital based on a simple philosophy:  “The best way to make money is not to lose it.”

We will walk you through our process to show how it can help you avoid the losses normally associated with a bear market.  We developed the Major Trend Indicator to lower market risk, which traditional asset allocation does not address.  The Major Trend Indicator has indicated that a bear market began on August 9, 2011.  Our money management clients were moved 100% out of the market on August 3, 2011, when the S&P 500 was 1250.

Expanation of the Major Trend Indicator in Bear Markets

Market Trend Risk – Investment style risk is most exposed as the stocks of even the best managed companies lose value during bear market declines.  Numerous studies have shown that the overall direction of the stock market contributes 50% to 70% of an individual stock’s price movement.  This was certainly the case during the bear markets of 2000-2003 and 2008-2009.  Traditional asset allocation relies on diversification to provide risk management.  However, diversification performed poorly during recent bear markets.

What’s obviously needed is an approach that addresses market risk and systemic risk, and provides true risk management. We developed the Major Trend Indicator to identify when a bear market has begun, so client funds can be moved 100% out of the market.  The MTI also attempts to signal when a rally within the context of a bear market is beginning.  This provides the opportunity to make money from the long side during a bear market.  At the end of every bear market, there is a rally that begins as bear market rally, but matures into a new bull market.  The benefit of already being invested as the new bull market kicks off is significant.

Bear Market 2000-2003

Let’s review how well the Major Trend Indicator addressed market trend risk during the bear markets of 2001-2002.

The 2000-2003 bear market began on October 11, 2000 based on the Major Trend Indicator.  The MTI gave a bear market rally buy signal in early January and a sell short signal in February as noted with the green up/ red down arrows.  The next buy signal occurred in April, and was reversed in June.  In October 2001 another buy signal was given, which lasted until December.  In 2002, there were buy signals in February and early May, and sell signals in April and late May to reverse each of the buy signals within about a month’s time (or a little less).  There was a large decline in June and July, which caused the market to get extremely oversold as measured by the MTI.

When the MTI reaches extreme oversold readings, it will not accept the first buy signal, i.e. July 2002.  Instead, it waits for the market to retest the prior low, and accepts the subsequent buy signal if it occurs at a less oversold level.  This took place in October 2002.  In March 2003, the MTI was far less oversold than in July and October 2002.  The pattern of the market retesting prior lows after periods of intense selling is fairly common, and was repeated in 2008 and 2009.  The bear market rally buy signal in March 2003 was strong enough to confirm the new bull market in April 2003.

Sell Short Signals

After a bear market has been signaled, a sell short signal is not given until after the model has first generated a bear market rally buy signal.  The bear market signal was given in October 2000, suggesting that the major trend was likely to be down in coming months.  A sell short signal is not given at the time of the bear market signal, since the market is often fairly oversold at that point.  The risk of a snap back rally is high, so going short is usually not profitable.  The first bear market rally buy signal occurred in early January 2001.  Sell short signals are generated, when the MTI turns lower and gives a sell short signal.

The first sell short signal was indicated in February, and remained in effect until the next bear market rally signal is generated, which was in April 2001.  After a weak buy signal in July 2001, the MTI gave another sell short signal in August 2001, before September 11, 2001.  This was followed by a fairly strong rally, after the bear market rally buy signal in October 2001.

This process is continued until a bear market rally is strong enough to push the MTI into the bull market zone.  This happened with the bear market rally buy signal in March 2003.  By late April 2003, the MTI was back into bull market territory.  This bull market lasted until the next bear market was signaled on January 10, 2008.

The table below shows the results of every MTI bear market rally buy signal during the 2000-2003 bear market.  In the calendar year, the S&P lost -12.02% in 2001, and -22.15% in 2002.  The bear market rally signals were profitable because the rallies were decent.  The MTI sell short signals were able to capture a portion of the declines during the 2000-2003 bear market.  The figures are based on the Vanguard S&P 500 index fund, which closely tracks the S&P 500.  See caveats at end of article.

Bear Market 2008-2009

The Major Trend Indicator signaled that a bear market had begun on January 10, 2008.  The first bear market rally buy signal occurred in February, but was quickly reversed in March.  Another buy signal developed before the end of March and lasted until May.  This was followed by a buy signal in July that reversed in September.  The Major Trend Indicator became extremely oversold in October and November 2008, so no buy or sell short signals were accepted.  In March 2009, the MTI was less oversold than in November, so the buy signal was accepted.

By May, the MTI had strengthened enough to confirm a new bull market.

The table below shows the results of every MTI bear market rally buy signal during the 2008-2009 bear market.  In the calendar year, the S&P lost -37.02% in 2008.  The bear market rally signals were not as profitable as they were during the 2000-2003 bear market because the rallies were weak.  The MTI sell short signals were able to capture a portion of the declines during the 2008-2009 bear market.  The figures are based on the Vanguard S&P 500 index fund, which closely tracks the S&P 500.  See caveats at end of article.

Caveats

1.  Every bear market is different, so there can be no assurance that the MTI will perform as it did during the bear markets in 2000-2003 and 2008-2009.

2.  Returns do not reflect management fees or potential trading slippage.

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About the Author

Macrotides is a monthly subscription newsletter written by a wealth manager associated with a major Wall Street investment bank. The author’s firm has requested that he not use his name to avoid any incorrect implication that his views might reflect those of the bank. The author has written investment advisory subscription newsletters based on macroeconomic analysis and market technicals for more than 20 years. Enquiries can be made at [email protected].