Bear market rules

I take no credit for the title – it comes from Mark Stevenson, an ex-colleague of mine and a charting guru – who now runs CLSA’s technical analysis in Asia. I met him last in mid-January, when I’d just turned bullish stocks after seven months on the bear side.

And Mark’s comment then was that it was right to trade for a rally. Bear market rallies can be fast and furious. We’ve seen 50% rallies in bear markets – the most notable being the 50% jump in the Dow Jones during the 1929-1932 bear market. We also saw one in the Nasdaq during the 2000-2003 bear market.

My favourite example of the power of a bear market rally was January 3rd, 2001. After a strong summer for stocks in 2000, the markets lurched badly in the last four months of that year, as it became apparent that tech orders had fallen off a cliff. You’d have been feeling pretty pleased with yourself if you were short the Nasdaq in the final three months of 2000. That was until you showed up in the office on the first trading day of 2001. Because the Fed had carried out an intermeeting rate cut the night before, and the Nasdaq jumped 14% in one session. There are times, even in a horrific bear market, when it ain’t no fun to be short.

So I felt happy to go long in mid-January this year, with the VIX above 30, and some of the worst sentiment readings I’d ever seen. I felt just as happy adding to positions in Mid-march.

But, while Mark was keen to trade a bear market rally, he was very clear – you had to follow ‘Bear market rules’. There are three parts to these rules. First off, take the money and run when the VIX falls back down from 30+ to the low 20s. The same when the relative strength of the market gets back up to 60. And watch out for big fibonnacci numbers – like 50% retracements of the previous falls.

Well, we’d pretty much had all of these as of a couple of weeks ago, when I got more cautious in my post; R&R.

And now the signals are getting more worrisome. The VIX fell back into the 17-19 range this week, a range that was poisonous for stocks in the high volatility 1998-2003 period. We’re still hanging around the 50% retracement of falls in the S&P, the China H-share and a range of other markets. The RSI is elevated, but in a downtrend that started last July. And worst of all, Barrons last week had a cover showing a bull dipping its toe into the water. That was after a 10% gain in stocks.

When I wrote R&R I put on a bunch of hedges – short S&P etc, to cover my long exposure in global resources and infrastructure stocks. I also got rid of some financials. I was too early – I lost money on the hedges and had to stop several out. But thankfully I made enough on my long positions to hold the overall portfolio pretty flat over the period, at around 14% up from the mid-Feb start. I’ve no problem with missing out on the upside from the move higher in the last week or two – I didn’t think the risk/reward was very good – so I saw no point in expending financial or psychological capital trying to ride the wave higher.

But I’m now coming to the view that the risk/reward of being long is getting toxic. So now I have three positions on in the leveraged part of the fund; two risk units short the Dow Jones, two units long Dec-08 Euribor, and one unit long the yen. At the moment these are hedging out about half my long portfolio – I’ll wait to see how the market behaves before building them up, or cutting them back.

And apart from technicals alone, I also think there are some decent macro reasons not to be too cheerful. Back in January, I thought that a combination of Fed ease, tax breaks, an end to destocking and strong exports could push the ISM back from sub-50 towards the mid-50s by Q308. Combine that with a steep yield curve, and you had perfect macro backdrop for a cyclical bounce in stocks. And that worked well – the market was able to look through the rotten data released over the past five months, to the prospect of better stats in Q3.

I now think that most of that is priced in. And now the macro backdrop doesn’t look so helpful. The yield curve has flattened after the vicious sell off in the twos. The sharp move higher in oil will eat into consumers’ real spending power. And there is mounting evidence that mortgage rates are remaining elevated, and lenders becoming more cautious, despite the low rate of Fed funds.

If the market could bottom out in mid-Jan to look through six months of recessionary data to a recovery beyond, what will it do now? My view is that it will look through four or five months of improving US data, to a slowdown beyond. Because, once the tax break is spent (if it is spent), we’ll be left with the same mess we started with; an overstretched US consumer facing the headwinds of falling housing wealth, rising unemployment, slowing nominal wage growth, and a big mismatch between income growth and the rising price of food and fuel. The US economy will likely be rolling back down the hill this autumn.

So I see little to gain, and a lot to lose, from swinging the bat at a big gain in stocks right now.