Wednesday, July 25, 2012

How To Invest In a Secular Bear Market

Bull and bear in front of the Frankfurt Stock ...
Bull and bear in front of the Frankfurt Stock Exchange (Photo credit: Wikipedia)
Our guest post is by Tony he invests in stocks, commodities, and currencies and blogs at A Young Investor


Before we begin, let's define what a secular bear market is. A secular bear market is a market in which, after more than a decade, is essentially flat. For example, stocks experienced a secular bear market from 1905 - 1921 (17 years), 1966-1981 (16 years), and from 2000 - present (13 years so far). So how does one invest in a secular bear market? Many of the strategies that work in secular bull markets (prolonged bull markets e.g. 1981-2000) don't work in secular bear markets.


Buy & Hold

Buy and hold is popular among long term and mom & pop investors. Buy it today, stuff it under your mattress, hold it for 20 years, and voila! You've just made 10% year-over-year! While buy and hold is great if we're in a secular bull market, such a strategy is doomed to fail in secular bear markets. Since the market is flat for a prolonged period of time, your investment will also be flat during those 10-20 years. Even if you were to buy on the dips, you would still only make a meager couple of percents year-over-year. As a result, only short term - medium term investors and traders make money in secular bear markets. But not all short-medium term investors and traders make money in secular bear markets.


Trend Following

Trend followers, investors who follow the trend (buy when the market starts rising and sell when the market starts falling) perform extremely poorly during secular bear markets. The whole idea behind trend following is that since one cannot predict which way the market will go, it's better to let the market start moving in one direction and then ride the wave. Such a strategy works well in secular bull markets when trends are long and obvious. However, this strategy is not suitable for secular bear markets because neither are the trends obvious nor are they long. Secular bear markets are characterized by short, choppy market movements, which is why trend followers get washed out very easily. E.g. they buy when the market rises, then the market falls, they sell, then the market rises, they buy..... As you can see, trend followers in secular bear markets die by the proverbal "death by a thousands cuts". So how can an investor generate decent returns in a secular bear market? Easy


Contrarian Investing

Contrarian investors (the polar opposite of trend followers) make the most money in secular bear markets. Here's how they do it.
  1. Identify the long term cycle. Is it a secular bear or a bull? This is easy to identify, because secular bear cycles usually last 15 years and secular bull cycles usually last 17 years.
  2. Identify the line of resistance. In a secular bear market, the line of resistance (the price that the markets won't exceed until the secular bear market is over) is usually the market peak at the beginning of the secular bear market.
  3. Whenever market sentiment reaches an extreme (based on a historical perspective) and prices fall extremely fast, it's time to buy. Think of market extremity like an elastic band - the more you stretch it to one side, the more it will rebound towards the other. Buy and hold until the market reaches the line of resistance stated in Step #2.
  4. Repeat the above steps until the secular bear market is over. Note: once the secular bull market resumes, continue with your previous buy & hold or trend following strategy.

2 comments:

  1. I'll be around to answer anyone's questions.

    ReplyDelete
  2. I use market cap to GDP as a proxy for the market Price to Sales ratio. Truly informative article to say the least.

    This is an interesting metric, but how does it account for corporate debt levels that vary over time (i.e., "enterprise value")? Or have those levels been fairly constant? On the other hand, how does it account for private equity firms that have taken many public companies private, thus lowering the "market cap to GDP" ratio? Or has the ratio of "go privates" to "new issues" (with the latter replacing the former) remained fairly constant over the years?

    ReplyDelete

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