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Trading the Stocks Cyclical Bear Market

Stock-Markets / Stocks Bear Market Jul 11, 2008 - 11:35 AM GMT

By: Zeal_LLC

Stock-Markets

Best Financial Markets Analysis ArticleEarlier this week, the flagship S&P 500 stock index (SPX) officially entered bear-market territory. As it edged past a 20% loss since its all-time high of October 2007, all debate about whether or not a bear really exists was instantly rendered irrelevant. Beyond any doubt we now sojourn in a full-on bear market!

The fearsome reputations of stock bears are well-deserved. During the legendary bear running between January 1973 and October 1974, the SPX lost a sickening 48.2% of its value. In a much more recent specimen, between March 2000 and October 2002 the SPX shed 49.1%. Cyclical bear markets often tend to cut stock prices in half by the time they fully run their courses!


While these raw numbers alone are frightening, realize this is across the entire broader markets. The 500 biggest and best companies in the US comprise the S&P 500. They are involved in 9 major sectors and a myriad of actual businesses. They are the investment-grade elites, the blue chips. Even these companies, all the giants whose names you know, can easily see their stock prices halved during a bear.

So needless to say, bears are exceedingly dangerous environments for investors. Fools ignore bears at their own great peril, and even the prudent are filled with plenty of trepidation. For the most part, you can't merely weather a bear by buying the best-of-breed companies. They will get sucked into the selling too. Other than sitting in cash, the only viable strategy for surviving, even thriving, in bears is actively trading these merciless beasts.

And it can be done. Back in 2002, the last cyclical-bear year until 2008, the SPX fell 23.4%. It was an exceedingly terrible year for the stock markets, a time of much wailing and gnashing of teeth. Yet the stock trades we realized that year from our Zeal Intelligence newsletter trading recommendations averaged 40.5% absolute gains. And since we held these for less than 4 months each on average, we were growing our capital at a 129.1% annualized rate. Bear be damned, it was a great year!

The key to successfully trading bear markets is understanding their primary driver, sentiment. The mission of a bear is to gradually hammer on investors until their perceptions of stocks radically change. When a bear begins, optimism and greed abound and traders are far too complacent. But by the time the bear ends, all hope has been beaten away. Pessimism and fear remain and traders are totally demoralized.

It is actually this excessive optimism that initially foments a bear. Near major tops, stocks get bid up to prices far beyond what their earnings can support. A bear is necessary to eradicate these valuation excesses . Over the course of a bear, valuations are slowly eroded lower until stock prices are cheap relative to their earnings near the end of a bear. So bears rebalance both sentiment and valuations.

And while the broad sweep of a bear is one giant slide from general greed to general fear, there are smaller sentiment sub-cycles within its duration. Traders get complacent after bear-market rallies, and scared after bear-market downlegs. It is these mini-greed-fear cycles within the longer greed-fear cycle of the entire bear that can be so profitable to trade.

To trade a bear, traders have to carefully monitor popular sentiment. And then when it gets to an extreme, they must do the opposite of what mainstream market thought considers right. When the thundering herd is scared, traders want to go long and buy stocks. When the herd is greedy or complacent, traders want to go short and sell stocks. Contrarian trading within bears is dazzlingly effective.

While monitoring consensus sentiment is something of an art form that comes with market experience, there are some great tools available to get quick reads. My personal favorite, and I believe the most effective, sentiment gauge is the VXO implied volatility index. By carefully studying and monitoring the VXO, traders can thrive in bear markets by fading the majority at both greed and fear extremes.

While implied volatility is mathematically intense, the basic concept is straightforward. All day everyday, traders are gaming an uncertain future via the stock-index options markets. Hedgers offload risk to speculators, all parties making bets to try and maximize their returns based on what each individual trader suspects is coming. Collectively all these trades, the sum of every single active trader's own bias and outlook, feed into options pricing models. The result is implied, or expected, volatility.

When traders get scared, they expect more volatility ahead so their options trades made in preparation drive implied volatility through the roof. When traders get greedy or complacent, they expect smooth sailing and their options trades reflect this. So implied volatility dries up. It is really elegant conceptually, using existing trades to define overall market expectations for near-future volatility.

How near? 30 days. The VXO calculates implied volatility for a synthetic, at-the-money option on the S&P 100 index expiring 30 calendar days out. If this sounds complicated, don't worry. The thing to internalize is a high VXO represents extreme general fear (the time to buy) and a low VXO represents extreme general complacency (the time to sell). The VXO effectively distills popular sentiment into one number.

Before I get into the mechanics of this, I have to digress briefly. The VXO is the implied volatility index for the S&P 100 (the top 100 companies, 20%, of the SPX) but the VIX is the implied volatility index for the S&P 500. So since everyone including me uses the SPX as the market benchmark of choice, why not just use the VIX? While it certainly can be used, I suspect the VXO is superior for a variety of reasons.

Until September 2003, the VIX used to apply to the S&P 100 (OEX). That month the CBOE changed it to track the broader S&P 500. And not only did the VIX's mission change, but a new formula was introduced for its calculation too. It incorporates a broader range of option strike prices, with weightings increasing closer to at-the-money. So today's VIX is totally new since late 2003, not comparable with the last bear's.

To preserve the true historical VIX, the CBOE renamed it the VXO. Thus the VXO was battle-proven in the 2000-to-2002 bear (where it was called the VIX) while today's bear is the first the new VIX has ever seen. While the VIX and VXO parallel each other closely most of the time, I like the VXO's proven track record. It is too bad the CBOE couldn't have named the new S&P 500 VIX something else instead.

And in bear markets, when fear surges, institutional traders rush to liquidate their biggest and most-liquid holdings to raise cash fast. This is the elite S&P 100 companies. As of the end of June, this top fifth of the S&P 500 accounted for 64.5% of its market capitalization. This is a big majority, no doubt, but it still means over one-third of the new VIX will be driven by stocks outside of the base S&P 100.

Thus I suspect at particularly ugly fear extremes, the VXO will decouple meaningfully from the VIX for a few days. The VXO will go higher faster, offering better trading signals. The top 20% of the SPX is just vastly more liquid in panic situations than the entire index. Big traders will dump OEX companies first as they have much higher volumes and much larger market caps so fast selling will have less of a price impact on any individual trader's realized prices on exit.

If my theory proves right in this bear, the old-school hyper-liquid VXO will more quickly and accurately reflect tradable fear excesses than the somewhat-watered-down VIX. Until I see how the VIX does over an entire cyclical bear, I'll continue to watch the VXO that has proven so useful in history. While I'll write a whole essay on the VXO versus VIX debate someday, that's the nutshell version if you're curious.

Digression complete, we can get into the actual bear-market trading mechanics. This first chart overlays the SPX on the VXO during the 2000-to-2002 bear. While that bear technically bottomed in October 2002, it retested those lows in March 2003. And that's when the mighty 2003-to-2007 bull began. Since most analysts today consider March 2003 the end of the early-2000s bear, I ran this chart out to early 2003.

The obvious inverse symmetry here is visually striking. During an in-progress bear, traders watching the SPX always wonder whether the index happens to be high enough for an interim top or low enough for an interim bottom at any given time. Watching the VXO simultaneously with the SPX helps resolve this conundrum. The VXO's largely-fixed range combined with its sentiment-mirroring nature shows when to buy and sell in real-time.

Since bear markets fall on balance, we'll start on the short side. Note above that each time the red VXO line headed into the low 20s the stock markets soon started falling again. S&P 100 implied volatility around 20 or lower signals either excessive greed or excessive complacency. Neither can last long in an ongoing bear. A low VXO, defined as low 20s and lower, is one of the best bear-market shorting signals.

Shorting encompasses a variety of trading strategies. If you happen to have long positions or call options still on the books from the preceding bear-market rally, they should be liquidated on a short signal to lock in your profits. New shorts or put options can also be added ahead of the coming bear downleg. No matter how you do it, on a low VXO extreme start positioning your capital to profit from market downside.

As the downleg foretold by the short signal matures, general fear really ramps up. Short positions grow very profitable and fewer and fewer traders want to try and “catch falling knives” and bet on a bounce. With few buyers, stocks plunge. Eventually fear gets so extreme that it becomes unbalanced and excessive. This is also reflected in the VXO, which is why it is most commonly called a “fear gauge”.

Back in the 2000-to-2002 bear, VXO extremes marking unsustainable fear, and hence an imminent sharp bear-market rally, gradually grew as the bear matured. Early on in late 2000, the SPX could bounce off a VXO peak in the upper 30s. By early 2001, this increased to 40ish levels. And in later 2001 and 2002, the fabled 50ish VXO levels of yore were witnessed.

So whenever the stock markets are falling fast and you are looking for a tradable bear-market rally, watch the VXO. It should peak somewhere between the upper 30s and 50 or so. That is when to close out all your short-oriented positions and throw long via stock purchases and call options. V-bounces within bears are driven by extreme fear, which is only driven by sufficiently sharp stock plunges.

This was the problem in the markets this week. As the SPX officially entered bear territory a few days ago, traders were looking for a rally. By itself, the SPX certainly did look oversold. It had fallen 12.8% on a closing basis in just 7 weeks! But fear wasn't excessive yet, the VXO was just nonchalantly meandering in the mid-20s. In the last bear, how many major bear rallies launched from such low fear levels? Zero.

Over the course of an entire bear, stocks gradually drift lower on balance. But from a tactical perspective, they bounce back and forth between greed and fear. Traders cannot expect a major new downleg unless greed and complacency are excessive. And they cannot expect a major new bear-market rally unless fear gets excessive. Bears need to be traded near these sentiment extremes, no other times are anywhere near as optimal.

So waiting for real fear, as reflected in the VXO, before closing shorts and adding longs is critical. And this begs the vexing question. Should I consider the upper 30s my long signal or should I hold out and wait until 50? Unfortunately there is no clear-cut answer here, but I do have a couple thoughts that have really helped my own trading.

First, realize popular fear gradually grows over the course of a bear. Early on, few people believe a bear is really upon them. Like the old slowly-boiling-the-frog-to-keep-him-unaware proverb, bears stealthily unfold so investors aren't spooked too soon. And with lower background fear earlier in bears, peak fear at extremes is also lower. Thus I'd be more inclined to call the upper 30s my long signal while this bear still remains young.

Later, as this bear matures, both background fear and spike fear levels will continue to ramp. So mid-bear I'll be watching for the low 40s on the VXO and by the last third of this bear (say spring to autumn 2009 or so) we'll almost certainly see VXO 50 again. As general fear grows, the VXO level at which a strong long signal can be declared will rise as well.

Second, greed and fear run along a continuum. Sometimes major trend reversals (from downleg to bear rally or vice versa) can happen at lower emotional intensities than usual. So hard-and-fast VXO targets, on both the upside and downside, are problematic. Instead, think in terms of a probability scale. The higher the VXO, the better your odds for success with longs. The lower, the better your odds with shorts.

So actual entry points can be scaled in and gamed a bit. If the VXO hits the upper 30s, close some shorts and add some longs. If it goes higher still after that (meaning the SPX fell farther), add more long positions. But once it gets to 50, even if only for a moment, it is time to throw long aggressively and close out all shorts. Historically the VXO rarely exceeds 50 and if it does it is for an exceedingly-short period of time. VXO 50 is as close to an absolute fear top as you can get.

Also realize that fear extremes heralding a V-bounce and major bear rally can happen anytime during the trading day. If fear peaks at noon , and no one is left to sell, the VXO will also peak at noon . Thus the intraday VXO high can be significantly higher than the closing VXO level. While these charts in this essay show VXO closes, at every extreme I noted two numbers. The lower one is the VXO close that day while the upper one is the intraday VXO high. They are both worth pondering.

The practical application for traders here is this. Once the VXO gets to 35 or so, start watching the darned thing religiously, every minute of every day. Odds are the actual fear peak, and hence tradable stock-market bottom, is not going to happen conveniently right at the end of a trading day. Another clue the bottom has arrived in real-time is stocks are in a free-fall and the CNBC talking heads are very frightened. After you see a few bottoms unfold, you'll know just what to look for.

All these lessons from the last bear can be applied to our current bear. While young, the VXO and SPX are already behaving very similarly to the ways they did early on in the early-2000s bear. I rendered this chart of our current bear at the same vertical scales as the previous one for comparability. Stocks are falling while both background fear and spike fear are gradually ramping. Welcome to the bear market!

Back in early October when the SPX bull finally gave up its ghost, the VXO fell to 15. These are very low levels showing extreme greed and complacency. But back then of course the cyclical bull had not yet failed. Low implied volatility levels are common late in bull markets as fear is long-forgotten. By late 2007 it had been five years since we'd seen a sharp selloff and fear-driven VXO spike!

But as 2008 dawned, increasing signs of a new bear market emerged. In January 2008, I wrote about the increasing odds for an impending cyclical bear based on Long Valuation Waves . After the March lows, we were riding the SPX bear rally higher in commodities stocks. But by early June, it was once again apparent that a new bear downleg was upon us. It has really accelerated in the past month.

So far in our young bear, we've only seen one full bear downleg (October 2007 to March 2008) and one full bear rally (March 2008 to May 2008). Since then, we've entered this bear's second major downleg. With this structural perspective of the ongoing SPX bear in mind, the VXO's behavior is very interesting and nicely echoes its famous characteristics of the past.

At the peak in October, greed was high and the VXO was very low. This was a great time to short with such abnormally-low implied volatility, even in a bull. While stocks soon started sliding, they really accelerated into January. Fears grew pretty intense for a spell. The January VXO peak on a closing basis was 33, not high. But intraday it approached 39, which is much more typical of an early-bear tradable bounce.

The SPX did indeed bounce, but failed to enter a full-blown bear rally. By March it was plumbing new lows that saw VXO tops of 34 closing and 37 intraday. Probably because fear wasn't too particularly extreme here, the subsequent bear rally wasn't all that impressive either. It only ran 12.0% higher from March to May, well under the 20.5% average for major bear rallies in 2001 and 2002. Of course that bear was more mature by those years than our cub today, which might help explain this.

But when the VXO again started falling under 20, and ultimately under 15 briefly in May, it was clear the bear rally was running out of steam. A new downleg was being born. So even in the young bear since October, using the VXO as a fear gauge to game major interim reversals has been quite profitable. I've talked about each reversal as it happened in our newsletters, and the VXO level was always a major clue. Watch the VXO closely, shorting at low levels and buying at high levels.

So trading bears is indeed possible, and quite profitable. And today it is easier than ever thanks to the proliferation of new ETF-like trading vehicles. Now stock traders can short stock indexes, and sectors, with leverage in some cases, directly out of normal stock trading accounts by buying ETFs. This is a vast improvement from the last bear when all we had was outright shorting and put options.

In the new July issue of our monthly Zeal Intelligence newsletter, I discussed many of these new bear-trading vehicles. You'd be amazed at all the neat new ways to game short-side exposure! I also discussed some of the reasons why this bear is likely to persist for at least another year or so, granting plenty of downlegs and bear rallies to trade. Subscribe today , join us in thriving through a difficult bear environment that crushes normal investors.

The bottom line is we are officially in a new SPX bear, and it remains quite young. While bears slaughter buy-and-holders, they offer outstanding trading opportunities. Prudent and disciplined contrarian traders who can buy when everyone else is scared and sell when they are not can earn fortunes over the course of a bear. The greed-fear-greed-fear downleg-rally-downleg-rally cycle is really fun to trade.

And the implied volatility indexes, particularly the classic VXO, are the best one-stop proxies for general greed and fear levels. The higher the VXO (fear), the higher the odds for success in new long trades. The lower the VXO, the higher the odds for success in new short trades. And this holds true regardless of where the SPX happens to be trading on any particular day.

By Adam Hamilton, CPA

So how can you profit from this information? We publish an acclaimed monthly newsletter, Zeal Intelligence , that details exactly what we are doing in terms of actual stock and options trading based on all the lessons we have learned in our market research. Please consider joining us each month for tactical trading details and more in our premium Zeal Intelligence service at … www.zealllc.com/subscribe.htm

Questions for Adam? I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/adam.htm for more information.

Thoughts, comments, or flames? Fire away at zelotes@zealllc.com . Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

Copyright 2000 - 2008 Zeal Research ( www.ZealLLC.com )

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© 2005-2022 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Comments

john
15 Sep 08, 20:33
bulls and bears

query, really. would like a simple explanation of "bulls and bears" in terms of traders. i know, i think, that one "buys low and sells high".

fine.

how, though, you can make anything out of "buy high and sell low" is something that i need a little help with.


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