Interactive Investor

Why a bear market really has started

15th February 2016 10:55

Lance Roberts from ii contributor

The action this past week has been, to say the least, dismal. However, the major lows that have been support for the bull market since 2009 continue to hold for now, but are under attack. We continue to watch these lows closely, as a failure would likely accelerate selling.

In every bear market, there are always opportunities, we just have to find them.

However, before I get into that, let me discuss why I believe we have currently entered into a bear market cycle. Last week, my friend Joe Calhoun at Alhambra Partners wrote a brilliant piece discussing what a bear market actually is:

Is this already a bear market?

The definitions of a correction as "down 10%" and a bear market as "down 20%" are just arbitrary numbers agreed upon by no one and everyone. And those thresholds, despite recent history, are met quite frequently. 10% corrections come around every couple of years and most of them are over before most investors get a statement that might scare them into doing something stupid.

20% bear markets are also pretty routine, coming along roughly one year out of four. Corrections and bear markets are generally over pretty quickly, even the ones that turn into financial crises. The 2008 bear market, from peak to trough, lasted 17 months; it only felt like a lifetime.

The real enemy of investors is not these fairly routine 10 or 20% downturns. The real enemy is the bear market that is associated with a recession or crisis, the one that knocks your equity block down by 40 or 50%. And actually, it isn't even the depth that is the real enemy.

For most investors, the enemy is time. Whether you are a younger investor still accumulating assets, a pre-retiree about to depend on your nest egg for income, or a retiree already doing so, bear markets eat up your most precious commodity - time.

Recovering from large drawdowns when you are young is obviously easier - if you stick to a plan and don't get laid off in the recession that caused it. But if you are about to retire, a bear market may mean you have to keep working for a few more years, putting a little tarnish on your golden years. If you are already retired it may mean something even more devastating - running out of money before you run out of years.

So, is this already a bear market? If we are measuring it for the S&P 500 in terms of price, the answer is no. But in terms of time? I think, for a lot of people, we're already there.

In short, the trend has changed, the inflection point between trending higher and trending lower is long gone. If you're still looking for it, I'm sorry to be the one to tell you, but you missed it.

The chart below shows what Joe is talking about:

Notice that, prior to both previous bull market peaks, price momentum turned from positive to negative. Likewise, at almost the exact peak, as now, the 13-month moving average changed from a positive to a negative slope.

Let's step back and take a look at the longer-term development and we can see the same behaviour. The chart below is the 200-400 day moving average crossover I have discussed previously.

Importantly, as I have annotated, at the peak of the previous two bull markets, both the long-term Wm%R and Full Stochastics [both momentum indicators] registered a trend change which was ultimately confirmed by the 200-day moving average (DMA) crossing below the 400 DMA. You were given plenty of warning to exit the markets before losing 20% of your money to validate the onset of a bear market.

I am suggesting selling into any rally over the next few days to reduce portfolio riskNotice that, during the correction in 2012, the registered sell signals of the Wm%R and Full Stochastics were never confirmed by a 200-400 DMA crossover.

Currently, both primary sell signals are in place and, with only a five-point spread between the 200 and 400 DMA, the confirmation of a bear market will be registered in the days ahead, unless there is a rapid rise towards old all-time highs. Given the current fundamental, technical and economic backdrop, there is little reason to expect such a sharp rise to occur.

Reducing risk, looking for opportunity

By reducing portfolio risk further this week, it now gives me cash, and substantially lower volatility, with which I can start looking for opportunities.

That's right, I am suggesting selling into any rally over the next few days to further reduce portfolio risk. Importantly, I said reduce risk. I did not say eliminate it. With the market oversold short-term, and the Federal Reserve an unknown wild card, I do not want to be completely out of equities, just in case "possibilities" overtake "probabilities".

If I am right, I will be able to reinvest capital at substantially reduced valuations down the roadLike playing the lottery, there is an almost non-existent possibility I could pick the winning combination.

However, the probabilities are heavily weighted against that outcome. By reducing risk, I can take my time to look for higher reward-to-risk opportunities to reinvest capital in the future.

If I am wrong, and the market doesn't decline further as expected, when the market regains its "bullish step", I can start buying again with a slightly higher relative degree of safety.

If I am right, and the market does have a further bear market correction, I will be able to reinvest capital at substantially reduced valuations down the road.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of "The Lance Roberts Show" and Chief Editor of the "Real Investment Advice" website and author of The "Real Investment Daily" blog and the "Real Investment Report". Follow Lance on Facebook, Twitter and Linked-In