Yahoo Finance How to Spot the Bear Market and Beat It
If stocks are in a bear market, the last thing investors need is to hear about it after the fact. It's as unhelpful as being told, "You should have been here yesterday."
The pullback in the Standard & Poor's 500 index hasn't yet reached the classic definition of a bear market, which is a decline of 20 percent or more. But by that measure, the drop is nearly here.
Are we headed for a bear market, and what should investors do? The answers are tricky.
Watch the bond market. "They just don't announce bear markets," says Eddy Elfenbein, who writes the Crossing Wall Street financial blog. But there are methods of detection.
Elfenbein says it's a harbinger of a bear market when interest rates on two-year government securities are higher than those on 10-year Treasuries. That differential in interest rates encourages investors to pull their money from long-term investments, such as 10-year Treasuries and stocks, and instead earn better yields for a short-term investment in the two-year bonds.
"We are nowhere near that now," he says. Two-year treasuries yield around 0.74 percent, versus 10-year notes that yield 1.87 percent. Longer-term investments, like stocks, still make sense.
While he doesn't see a bear market now, Elfenbein says he likes to keep a famous and sobering investing quote from ace stock picker Peter Lynch in mind: "Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves."
The Dow theory. Other industry practitioners are less sanguine. Jeffrey Saut, chief investment strategist at Raymond James, uses the Dow theory -- a method of watching the Dow Jones industrial average, which reflects the health of the industrial economy, and comparing it to the Dow Transport index, which reflects the health of the haulage business.
The idea is that if the transport sector isn't moving higher with broader Dow, then something is wrong in the economy. After all, transportation is needed to move the goods that the industrial sector buys and sells. If transports aren't doing as well as the industrials, then there is likely a problem.
Saut says he's already spotted a sell signal based on Dow theory in late August. He decided it was an aberration and opted not to act.
Still, if the Dow falls back below the closing low of the August market meltdown, which was at 15,666.44, then he would be concerned enough to act and increase the proportion of cash he holds in his portfolio. "We had close to a 20 percent decline in 2011 and I survived that by raising cash," he says.
Follow the trend. Other analysts look at the general price trend of the indexes, with the idea that a trend will continue indefinitely until another force comes into play to change the direction. Think of it like Newtonian laws of motion.
One way to determine the direction of a trend is to look at the price of an index in relation to two key moving averages, says Vinny Catalano, president of Blue Marble Research in New York. He looks at the 50-day moving average and the 200-day moving average. Each is calculated by averaging the previous days' prices over the defined period. As a result, the averages change every day.
Three factors indicate a downward trend: The index must be trading below both the 50-day average and below the 200-day average, the 50-day moving average must have crossed below the 200-day average, and the slope of the moving averages must be pointing down. He claims this method has been accurate more 75 percent of the time in the last 21 years as an upward or downward indicator.
"We have all three (indicators) now," he says.
Like Saut, he says raising cash is a good idea. He also takes an aggressive approach of looking at exchange-traded funds that benefit from falling prices, so-called inverse funds. Currently, he likes and owns the ProShares Short MSCI Emerging Markets (EUM), which gains when emerging markets stock markets drop. That's because those markets will likely be hurt even more than U.S. markets.
He also throws in the idea that small investors could follow the practice of Berkshire Hathaway's (BRK.A, BRK.B) Warren Buffett and just hold their stocks. For many small investors, that may be the best alternative.
Everyone is losing money. "We are in a bear market," says Jeff Macke, independent investor and contributor to the investing website ibankcoin.com. "You know we are because just about everyone is losing money."
A bear market doesn't just indicate that the normal investing tactics are simply reversed. "For the most part everyone loses money," he says. Those who do make money, bears or bulls, get in and out of their trades quickly.
He uses the following example about tech giant Apple (AAPL), which has declined significantly over the past few months. "Three months ago Apple holders were telling me that they were long-term investors, but when the stock is down more than 20 percent, that changes everything," Macke says. "Then they get mad and yell at the TV pundits."
You'll know the bear market is over when investors and traders start throwing in the towel and don't even want to consider stocks again. So when those Apple fans ditch the stock, you'll know the bear has left.
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