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Phases/Stages of a Primary Bear Trend: Psychology Rules

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I've written some columns in past weeks, both in my online Option Investor "Index Trader" section and in my weekly Trader's Corner about what Dow Theory might be telling us about this current trend and if the market has shifted to what Dow would call a 'primary' bear market. This is about much more than graphs and charts, as Charles Dow, the grandfather of technical analysis in the West was extremely perceptive about market psychology (the psychology of market participants as a whole) as a key to understanding what PHASE the market was in. There are phases of a bull market and distinct phases of bear market and because human nature hasn't changed, these have been the same over the last 100+ years or since Dow's time.

First, what is better known about Dow theory is about the two Dow Averages together 'confirming' the primary trend in the market. That is summed up in the chart, many of you have seen before and don't (groan!) worry, this is just a passing reference. The suggestion is that a market reverses its primary trend when the Dow 30 Industrials (INDU) and the Dow Transportation (TRAN)Average BOTH close above or below their respective prior major closing weekly or monthly high or low.

In our present situation, the primary trend, according to Dow theory, is now DOWN with probably entry into a primary bear market. Speaking of primary, my principle focus in this article is on how to tell what PHASE, beginning, middle or end phase, the market could be in for this current and future bear market. And, of course, there's mixed opinions on whether we have or are entering into a bear market.

I've used for many years an indicator that measures the ratio of daily CBOE equities (only) call and put volumes as my primary sentiment indicator. 'Sentiment' is simply a way to describe how traders and investors FEEL about the market and what they feel is going to be its future DIRECTION, up or down. Market sentiment indicators like mine attempt to measure traders and investors short to intermediate-term outlook for stocks and apply a 'contrary opinion' overlay to this outlook measurment.

It appears to be true that over and over, at key trend reversal points, certain 'EXTREMES' in bullishness or bearishness will PRECEDE trend reversals; in the case of my indicator, by 1 to 5 trading days. This per my contrary opinion sentiment indicator plotted below the daily S&P 100 (OEX) chart. This indicator just happens to reside on the OEX chart, but is a very useful trading indicator in predicting ahead of time, trend reversals in all the major market indexes at least a short-term (2-3 days) and more likely on an intermediate-term basis (2-3 weeks).

LONG-TERM PHASES OF MARKET PSYCHOLOGY ACCORDING TO CHARLES DOW:

In this country, the originator of what became knosn as 'technical analysis' is Charles H. Dow, the late 1880s co-founder of Dow Jones & Co. and its flagship newspaper, The Wall Street Journal. Charles Dow was born in 1851 in Connecticut and had the image of what is sometimes associated with a New England type of personality: sober, industrious, and rather serious-minded. He was a reporter and editor most of his life, which ended in 1902.

I worked for Dow Jones Telerate for a few years in the 1990s and organized the establishment and rules governing the Charles H. Dow award, given annually by the Market Technicians Association (MTA) of which I was a member, for outstanding achievement in technical analysis work. Like the man himself, I stipulated that the Award given in Dows name be awarded for work that stressed practical uses of technical analysis.

CYCLES OF BULL AND BEAR MARKETS HAVE THE SAME REOCCURING PHASES
The phases of both bull and bear markets, while different of course in direction and relative investor psychology (optimism versus pessimism), are similar in terms of two factors:
-- Relative knowledge about the market
-- Investor 'sentiment'(attitude) about the market that ranges from disinterested to indifferent to interested; with varying degrees of intensity within disinterested and interested

A Bear Market:
The animal analogy is quite apt, as the bear can both be very fierce and unforgiving, or can just go to sleep for a long period. Bear markets can usually also be divided into three phases. That this does not always occur is seen in the 1987 bear market that was sharp and steep, but with the decline only lasting two months. After that, there was a slow gradual process of advancing prices during which significant bearish sentiment remained and and people swore off the market because of the market crash that had occurred. This phase didnt reach the typical bearish extreme however, as within 7-10 months the market in terms of the Dow 30 had recovered nearly half of its October-November decline.

1. DISTRIBUTION
The first phase of a primary bear market tends to be a period of distribution. 'Distribution' begins in the final phases of a bull market. It is the phase where selling begins by the same type of experienced investors that havent gotten overly swept up in the extremes in emotion and price that can occur with less knowledable investors. This group has the foresight and knowledge of markets to understand that company profits have probably reached their peak and that the price multiples paid (the P/E ratios) for those earnings are also at extreme levels. They began to sell or 'distribute' stocks to the still eager and willing buyers. Volume of trading begins to slow. The public is still in the market heavily but may be getting frustrated as the rate of increase slows down and not all stocks participate on rallies.

The distribution phase is also one where people who may not be usually in the market also become buyers of stocks. The market has gone up for so long typically, that people not in it already think they should be or 'have' to get in on this gravy train; greed is a definite psychological factor here.

2. PANIC SELLING
Panic is a significant if not major characteristic of the second phase of a bear market. Buyers become scarce, bids falls sharply and sellers become desperate to get out. The downward acceleration becomes extreme and a near vertical drop can ensue. Well, we have seen some sharp down days and weeks in recent months as you know.

The decline goes on longer when there is very strong CONVICTION about the continuation of the bull market that has ended already: the investing public, in general, does not believe it or doesnt want to believe that the overall bull market has ended. The handmaiden to fear, so speak, is hope. There is a reluctance to take a loss in stocks, especially a sizable one. Better to hope for a recovery. This is the phase where people will make a point of telling you that they are "long-term" investors. Investors have become conditioned to stocks going up and will maintain their faith in a market rebound for longer than is warranted by facts. Hope springs eternal as is said.

We are currently I believe seeing much still-strong convictions out there about the bullish long-term prospects for equities. While the favorable prospects for stocks have proven to be TRUE over the long haul, I am talking here more about people's BELIEFS in and about the market and whether they will hold on to these beliefs about the good prospects for stocks if they see erosion in the value of their stock funds/portfolios for many months.

3. DISCOURAGEMENT
After the worst part of the decline or where prices are not dropping so steeply and which can be at the point where the economy has stabilized, there can come a gradual market recovery and a rebound in prices of the stocks of the strongest companies. Or, this may be a long period where the market trends sideways.

This is the third phase and is marked by discouraged sellers, perhaps those that didnt sell in the panic atmosphere that had prevailed earlier. Or, this selling could be coming from those investors and traders who bought during and after the steepest declines as they thought stocks looked cheap relative the inflated values of the late bull market stage.

What causes this discouraged selling is that the rallies arent sustained and prices sink lower. Theres an old analogy about the erosion of a bear market being like a faucet dripping. Such slow steady loss, over time, becomes buckets. Business conditions at this stage may deteriorate further. Certainly there is an absence of good news with corporate earnings as the economy slides further. The stocks that were very speculative, in terms of their potential to make money, may lose most of the rest of the their value in this phase.

There were many Nasdaq stocks that lost 80-90% of what they had gained in the prior bull market, in the 12 months after the March 2000 top. Blue chip type stocks tend to decline more slowly because investors hold on to them the longest

A bear market ends when all the possible bad news has been discounted. And it after it ends, there is usually more negative news that keeps coming. Keep in mind that the 'discounting' mechanism of stocks is always also an attempt to look ahead, so stock values will reflect the expectations of what earnings could be when business conditions improve; for example, about six months ahead.

It also should be noted that no two bear markets are exactly alike. The 1987 bear market was amazingly short in time duration and could be measured in weeks, although the price declines were quite severe. Some bear markets skip the panic stage and others end with it as in 1987. Bear markets go on for quite different time and price durations. Of 13 years with significant declines in the 40 years preceding the March 2000 March 2001 market drop, 6 have had steeper sell offs in percentage terms as measured by the S&P 500 Index. If we measure by the Nasdaq market, the aforementioned 2000-2001 period, which saw a drop from peak to low of 68%, relative to 1987s loss of 37%, may continue to be a record.

The important information to have is that however long the phases are, such as was seen in spectacular bull market run up of the 1998-2000 period, the characteristics of each phase will help you keep a level head. You know what is coming when the phase you are in, ends and you can prepare for it. Keep in mind also, that the descriptions were made over 100 years ago. I have added more up to date examples, but the nature of them remains human nature. This relatively unchanged human nature, yours and others, is what you have to deal with in the stock market and it benefits you greatly when you can see which market phase you are in.

ANOTHER, MODERN, TAKE ON THE POTENTIAL PHASES OF A BEAR MARKET!

My favorite financial blogger is Barry Ritholtz, the Chief Market Strategist for Ritholtz Research, an independent retail and institutional research firm that looks at macroeconomic trends in the capital markets.

Barry had this great analogy about the "5 Stages of Market Grief". In his own words as follows:

"One of the most intriguing things I find about the market is how the collective psyche sometimes resembles a singular entity. In particular, I have been fascinated by the commentary we have heard from some quarters regarding deep and obvious flaws in the present macro environment. I spent a lot of time over the recent holidays (skeptically) reading commentary from various pundits. There was something strangely familiar in the absurdly erroneous observations, but I couldn't place my finger on what it was.

Until just recently and I don't know who or what actually triggered my memory, it finally dawned on me what the parallel was: The "Kbler-Ross" model of the 5 stages of grief.

For those of you who never took any psych in college, that is the process by which us humans deal with grief and tragedy. It was introduced by Elisabeth Kbler-Ross in her 1969 book "On Death and Dying". This has become well-known as the "Five Stages of Grief." They are:

1. Denial
2. Anger
3. Bargaining
4. Depression
5. Acceptance

Reviewing recent market commentary, it appears that the investors, traders and pundits alike have been working their way through each of these 5 stages. Consider:

1. Denial: For the longest time, the consensus was that Housing issues wouldn't impact anything else. Classic denial was demonstrated by the insistence that first Housing, then the credit crunch, was "contained."
There has been a multi-step process for the deniers (denialists?). Initially, they insisted there was no housing slowdown. Then, any slowdown would not impact consumer spending or the broader economy. The 3rd denial step was that while it was no longer contained, any damage would be mild. The most recent denial was that while the Housing issue has been worse than previously believed, it is now fully reflected in stock prices.
'Me thinks they doth protest too much'!

We saw the same denial steps in inflation, consumer spending, and job creation. The denial transition went from: a) No slowdown; to b) Slowdown, but no impact; to c) Impact, but contained; to d) Broad impact already reflected in stock prices.
>
2. Anger: The details of this were personified by Jim Cramer's Fed rant. After spending the prior year discussing 'that Housing was fine' (February 2007), and pointing out each 'bounce in the home builders' (November 2006) was proof the Housing bottom was in, Cramer's incredible meltdown (the aforemention Fed 'rant') was stark evidence that the denial stage was over, and the classic anger stage was beginning.
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3. Bargaining: I believe we are now at the bargaining stage. This is reflected in the increased expectations of a 50 basis point rate cut (If the Fed cuts aggressively, stocks will be fine). Buying falling knives is a form of bargaining (If I avoid momentum plays and only buy cheap stocks, I'm okay).
Yet another example I've been seeing: "Invest Now in Anticipation of Recession Recovery."

What's next? Well, steps 4 and 5:
Depression
and
Acceptance
have yet to occur this cycle.

If you were an active investor, or better yet, in the business, recall what your psyche was like in mid-2002. That was Step 4: depression. The screens were red all day, investors refused to even open up their monthly statements, no one wanted to take your calls. It was fugly. That's what depression is like.

Step 5 (Acceptance) was when people finally admitted it was over: that stocks had their day. Hope was extinguished, and perhaps real estate or commodities might be a better play. Incidentally, stage 5 is a great time to buy equities.

If this parallel to Kbler-Ross continues to hold, and if my approximation that we are only at stage 3 is correct, then we have some downside work to do before this is all over"

Thank you Barry!!

The 'depression' and 'acceptance' phase that Barry Ritholtz describes above from the "5 Phases of Grief", also describes or overlays the Phase 3 'DISCOURAGEMENT' phase that Charles Dow talked about, but perhaps in a more colorful and modern (in terms of psychology) way.

GOOD TRADING SUCCESS!
 

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