Buying into a bear market

I want to discuss what to many is very scary: buying into a bear market. First, a disclaimer. There is a word to describe those who always discern the exact bottoms of bear markets, and that word is "liar." Over my money management career, which spanned twenty-seven years, I experienced the stress of at least four bear markets. (I retired at the end of 1995 and, thus, did not have to cope with the bear that started in March, 2000.) You probably have heard the expression that trying to find a bear market bottom is like "trying to catch a falling knife." What I would like to accomplish in this post is to have you look upon a bear market as an opportunity rather than a terrifying event that paralyzes you from taking action.

As an aside, the worst bear market I ever experienced was that of 1973-74, which resulted from a perfect storm of an overvalued market, recession, and high interest rates. I know one small cap growth mutual fund manager who had two consecutive down 40% years. Another person, who ran one of the few hedge funds at the time, had a terrible two years and would wake up in the middle of the night sweating and wondering whether he would soon be driving a cab. The first guy rebounded and eventually retired a couple of decades later a with a huge net worth! The hedge fund manager became a leading Wall Street pundit! The moral of these stories is "Don't despair!"

There are two necessary conditions that must occur before I would buy into a bear market: 1) a "contrary" sentiment indicator, Investors Intelligence's survey of advisory sentiment, must indicate at least 60% bears and no more than 20% bulls; and 2) the bear market must have retraced the previous bull run by a Fibonacci number.

Sentiment indicators are contrarian indicators.  Those that measure investor bullishness and bearishness are valuable when there is an abnormal amount of either. For example, when there is an extreme of bullishness, the assumption is that most who want to buy are already in, and the market will soon start down. The opposite is true in the case of a very high level of bearishness. I must warn you that these sentiment indicators are only predictive at extremes. They are threshold indicators, not linear ones. In other words, a move in bullishness from, say, 48% to 50% is just noise, with no predictive value. I have been keeping the advisory sentiment figures for forty years, and have only acted on them fewer than a dozen times. This approach obviously takes discipline and patience. The publishers of these indicators sometimes recommend to readers that they taken action when the indicators haven't reached extreme levels. In my opinion, that is dangerous.

Investors Intelligence has been publishing their survey of advisory sentiment every week for decades. I find them the most reliable sentiment indicator. They used to publish their weekly findings in Barrons, but that was ended a few years ago. Their survey is, however, available to subscribers for an annual fee of several hundred dollars, a very wise investment.

The concept of Fibonacci numbers has a mystical quality to it. However, many money managers use them. For a lengthy explanation of them you might want to Google "Fibonacci numbers."
The important Fibonacci numbers for money managers are .382, .500, and .618. I look at these as percentage retracements of the previous bull market move that occurs during a down market. Thus, possible buy points might occur after 3/8, one half, and 5/8 retracements of a previous bull market move. For purposes of example, let's take the current bull market, which started at a Standard and Poors 500 Index level of roughly 775. Let's assume that the 2007 high thus far of 1460 is a bull market high. Retracements of 3/8, 1/2, and 5/8 of the 685 point bull market move would be levels of 1203, 1118, and 1032 in the Standard and Poors 500 Index. How would you determine which of these levels would be buy points? There is usually symmetry in market cycles. That is, if the amplitude and duration of the previous bull market were long, then the ensuing bear market would likely be the same, so that, under those circumstances, I would wait for the 1/2 retracement to begin buying rather than the 3/8 one. (As I have written above, this buying would only occur if the sentiment indicator had also kicked in.)

Most bear markets end in what is known as a capitulation phase, selling climax, or puking phase. They all describe a scenario where the selling accelerates on very high volume. At this juncture, there is irrational selling. Many sellers have had enough of the pain and just want out!--which provides a
great buying opportunity for those with patience and discipline. A contemporary way to time a selling climax is when the VIX indicator of option implied volatility reaches levels in the 40-50% range.

After a bear market low, usually there is a successful test of that low. The Standard and Poors 500 Index might even penetrate the former low, but there are fewer stocks within the index making new lows at that time. So even if you miss the low, there is an opportunity to get in soon thereafter.

One might ask, "Aren't you ignoring fundamental analysis"? Despite being primarily a fundamentalist, I have found that fundamentals are of no value in recognizing bear market bottoms. I have often said that if I could make only one phone call during a bear market to help me find a buy point, it would be to Investors Intelligence.