Strategies For When The Bull Market Finally Dies

Includes: DIA, QQQ, SPY
by: Eric Parnell, CFA

It is a common refrain heard from stock investors today. Recognizing that the current bull market is nearly five years old and that the risk remains for a potentially major correction at some point in the future, many investors have found comfort in the following belief: "I'll stay invested in stocks until the market tops out, and then I'll sell and get out once the correction is underway". While such a seemingly straightforward strategy would work great in an ideal world, unfortunately for most investors this is much easier said than done. For the stock market bear is a grizzly beast, and it has a long history of taking out the best of investors once it finally unleashes its wrath. And since the next time around has the potential to become particularly violent, now is the time to begin developing a defined strategy to identify when today's bull market finally dies and a plan for how to escape largely unscathed.

Reflecting on the two most recent major bear markets is highly instructive for two reasons. First, it provides insight in understanding why it is so difficult to escape a bear market once it is underway. Also, it presents investors with key signals to monitor to determine whether the bull market remains in tact or if a new bear market phase has begun.

Dissecting The 2000-2002 Bear Market

Much like today, the first major bear market to start the new millennium was long overdue once it finally arrived in early 2000. Complicating matters for investors at the time was the bear market head fakes that occurred along the way. The stock market as measured by the S&P 500 Index (NYSEARCA:SPY) had a virtually uninterrupted rise higher above its 200-day moving average from January 1995 to August 1998. But it was in the late summer of 1998 that it seemed that the bull market had finally reached its end.

Stocks broke decisively below its 200-day moving average in August 1998 driven in part by the ongoing Asian financial crisis and the Russian ruble crisis. And the pressure on the market quickly accelerated not long after in September 1998 with the collapse and eventual rescue of Long Term Capital Management (LTCM). Given the fact that earnings had been flat to trending lower for two years since the summer of 1996 and stock valuations had risen from P/E multiples the mid teens to the mid 20s, the fact that the stock market was finally capitulating seemed long overdue. And after an attempt in late September to reclaim the 200-day M.A. failed and stocks rolled back over to hit new lows, it appeared that a new bear market was firmly underway. But stocks suddenly found their footing in the aftermath of the LTCM rescue in mid October. By the end of October, stocks prevailed in a second showdown with the 200-day M.A. and were off to the races to the upside.

The stock market events of late 1998 is the first example of what makes the decision to try and exit at the market top extremely difficult, as the false bear market starts only serve to embolden the bulls even more. The rational investor with valuations at nosebleed levels and earnings already trending lower would have likely moved to the sidelines from stocks in the midst of this 1998 episode if they hadn't already in advance of it. But stocks suddenly recovered and went on to rally for another 18 months. Even though the more rational investors that stepped away from the markets in late 1998 were ultimately proven correct, 18 months is an unbearably long time to appear not only wrong but also downright stupid. And it is for this reason that so many investors including some of the very best in the business were sucked back in to the stock market before it collapsed. As for the bulls during this period, they not only felt confident, they felt downright invincible as the market soared to all-time highs by early 2000.

It was at the market peak in March 2000 where the second challenge is presented to those that seek to hold on and exit the market at the top. One of the most common misconceptions when reflecting back on the bursting of the tech bubble was that the decline in stocks from March 2000 to October 2002 was simply a straight line lower. But this was not at all the case. Instead, it took roughly a year before it started to become clear that a bear market was underway. And for many investors, it was already too late by then to escape the markets without suffering great harm. For example, although stocks had already peaked in March 2000, the market uptrend remained in tact for another six months through September 2000 with stocks nearly breaking out to fresh new highs along the way. And even after stocks broke below support at its 200-day moving average in late September 2000, if anything it looked like a repeat of the episode that had played out around the same time in 1998 and to a lesser extent in September/October 1999. In short, this was shaping up to be another great October buying opportunity in 2000.

It was after the market finally broke in September 2000 where the next challenge for investors began to fully unfold. For it is at this point that investors are already effectively stuck in a bear market while believing they are still in a bull market. With bullish sentiment at a whopping 64% according to AAII, investors eagerly buy the latest October dip in 2000. And on script, the stock market starts to surge up toward its 200-day average at the end of October. But then the unthinkable happens. The rally fails at what has suddenly become resistance at the 200-day moving average, and stocks tumble back to new lows by the end of November. The bulls still have no worries with bullish sentiment still at 60% during a seasonally strong period heading into the month of December.

Of course, we saw the market fail once before it finally broke back out in 1998, so investors remain confident that this remains a good time to buy the dips. And although December turns out to be choppier than expected, the Santa Claus rally comes in to lift the markets and suddenly everything feels back on track in January 2001 with stocks breaking back out above its 50-day moving average. It's been a tough stretch over the last few months, but investors are only down -10% from the market highs last seen in September and it appears that the bull has regained its footing.

Of course, it is at this very moment that the lights go out and the door slams shut on most investors, trapping them in the bear market that follows. Over the next eight weeks through the end of March 2001, stocks cascade lower by -21%. Quickly, investors are now down -30% from the peaks from just six months ago. The plan to exit the market once the bull market tops and the bear market gets underway is gone. Instead, investors are faced with the unpleasant dilemma of locking in losses and missing the bounce or continuing to hold and suffer more declines. For those that hang on, it soon appeared that the worst was finally over, as stocks vaulted higher by +22% through mid May 2001 and were once again knocking on the door of the 200-day M.A. And corporate earnings that had suddenly dropped in late 2000 and early 2001 were starting to show signs of bottoming. Unfortunately, this turns out to be one of the many recovery head fakes offered up by the vicious bear market as it drags its investor prey all the way to the bottom more than a year later in October 2002 and another six months beyond into March 2003 before finally going back into hibernation.

It is worth noting that the Fed was lowering interest rates aggressively throughout most of the 2000 to 2002 bear market. Thus, the "don't fight the Fed" mantra has its bounds. Also, earnings had bottomed and turned higher for nearly 18 months before the market finally entered into a new bull market phase in early 2003. In other words, valuations do matter and stocks had to return to P/E multiples in mid to high teens on an operating earnings basis before finding their footing to start moving sustainably higher. Unfortunately for investors, most have a memory that is only about two years long. As a result, we found ourselves doing the same thing all over again just four years later.

Examining The 2007-2009 Bear Market

The bear market of 2007 to 2009 has remarkably similar characteristics to its predecessor despite the meaningful differences in their underlying causes. Thanks to another heavy dose of easy money from the Fed, the stock market enjoyed another virtually uninterrupted bull market rise from 2003 to 2007. Outside of the occasional cup of coffee below the 200-day moving average, stocks steadily climbed all the way back to their 2000 highs by July 2007. And with corporate earnings steadily on the rise and P/E multiples at their lowest levels since the early 1990s, it appeared that the sky was the limit for the stock market in the years ahead.

Unfortunately, as we all know, a world of financial trouble was brewing under the surface by mid 2007. But just as we saw in the 2000 episode, the stock market was late in reflecting the massive troubles ahead. Stocks first broke below their 200-day moving average in August 2007, but quickly reclaimed this level en route to new all-time highs by early October 2007. And after having raised interest rates to 5.25% the previous year, the Fed had begun easing again with 75 basis points worth of rate cuts. The bulls had the wind in their sails and the Fed on their side.

But just as it was in the previous bear market, the descent to the bottom over the next eighteen months was neither sudden or a straight line lower to the bottom. And also like last time, it was at this point that investors were already unwittingly stuck in a bear market. After peaking and holding generally steady in October 2007, stocks suddenly lurched to the downside, losing -10% of their value over the course of just three weeks. But just as it was in late 2000, this was simply the buy the dips opportunity for which so many bulls had been waiting. And it was all the more ideal for the bulls that the pullback occurred during the seasonally strong year-end period. Over the next two weeks, stocks delivered with a strong +8% rally through mid December that included a breakout back above the 200-day moving average. But suddenly, Santa Claus did not show up much for the markets to close out 2007, as stocks thrashed back and forth in losing its grip once again on the 200-day M.A.

It was with the turning of the calendar to 2008 that the lights went out and the doors slammed shut on those investors with any idea of getting out at the market top. At the end of 2007, stock investors were only -6% below the all-time highs. But over the course of the next few weeks in early January, stocks cratered by -14% and investors suddenly found themselves in a market where they were -20% below the highs. Stocks managed a feeble rally into early March when the first major landmine of the financial crisis suddenly explodes. Bear Sterns, whose stock was trading over $80 per share only a few days earlier suddenly collapsed to less than $5. Reminiscent of the LTCM bailout a decade earlier, the Federal Reserve coordinated a rescue of Bear Sterns by JP Morgan Chase for the bargain basement price of $2 per share.

But with the S&P 500 holding support at 1275 in the aftermath of the Bear Sterns rescue, many leading market pundits were openly declaring that the bottom for the stock market was set, as this action demonstrated that the Fed and the U.S. Treasury would do whatever it takes to support the troubled financial system. And for a time, it seemed a most prescient call and that those hanging on in hopes of a recovery would be saved, as the stock market rallied an impressive +15% from the Bear Sterns lows through mid May to find itself once again up against its 200-day moving average. And with the Fed now fully engaged in lowering interest rates and earnings data showing signs of mending in early 2008 from the notable drop that had occurred in fourth quarter of 2007, the case was certainly there for the bulls to make that the worst was finally over. So when stocks bounced off of 50-day M.A. support after first failing at the 200-day M.A., it seemed only a matter of time for the bulls before the breakout would finally occur.

By May 2008, we were nearly a year after the initial market peak in July 2007. And stocks were only -9% below their highs at this point. Those investors wishing that to exit the market before it corrected had good reason to believe that the worst had passed with the rescue of Bear Sterns and that the bull market could simply resume with valuations still reasonable and earnings on the mend. But what followed over the next nine months was one of the worst and most gut wrenching declines in stock market history. While stocks managed to hold their July 2008 support levels at around 1200 even through the first three weeks after the collapse of Lehman Brothers in September 2008, investors still found themselves -24% below the highs and caught once again in the dilemma of locking in losses and missing the rally or continuing to hold and suffering more losses. But once the calendar flipped to October 2008, the game was officially over, as stocks declined -28% over the course of just eight trading days to start the month en route the raging bear dragging investors to a -60% peak to trough decline by March 2009.

Once again, investors had the Fed firmly in their corner with unprecedentedly aggressive monetary policy support throughout the entire bear market. They had every reason to think a bounce back was right around the corner, but what followed was more losses. And while the medicine finally kicked in by March 2009, investors still had to endure a -60% trauma that they were not likely to soon forget. Or then again, maybe they would forget it more quickly than imagined.

Bear Watch: Escape Strategies For The Next Bear Market

Stocks do not rise to the sky. Eventually they will enter into another bear market. And after five years of market advancement that has been interrupted only when the Fed has backed off from its extraordinarily aggressive monetary policy support, we are potentially drawing close to a new bear market phase. So what can we expect the next time around? And what lessons can we draw from the past two episodes to help us navigate as best as possible?

Much like the first market cycle around the turn of the millennium, today's rally included two major bear market head fakes.

The first came in the summer of 2010 after the Fed concluded its QE1 stimulus program when stocks broke below their 200-day M.A. in May 2010 and remained trapped below this resistance level through mid September 2010 with two failed breakout attempts along the way. It was only after the Fed announced its intent to launch QE2 that stocks finally reclaimed their move to the upside. Another factor working in favor of stocks at the time was the fact that earnings growth was still recovering nicely from the financial crisis and P/E multiples were still fairly reasonable in the mid teens.

The second came a year later in the summer of 2011. Once again, this took place just weeks after the Fed concluded its QE2 stimulus program with stocks breaking decisively below their 200-day M.A. in August 2011. But unlike the 2010 breakdown, stocks were showing little resilience with no meaningful rebound toward the 200-day M.A. and a breakdown to new lows by early October 2011. And while stock multiples were still fairly reasonable, corporate earnings had not only stalled but were beginning to roll over. With three failed attempts to break out above its 200-day M.A. and reclaim its uptrend by the end of the year, it looked like 2012 was shaping up to look a lot like 2001 with countertrend rallies failing as the market finally began cleansing itself of the remaining excesses left over from the financial crisis.

The rational investor might have viewed the set up in 2011 as a reasonable time to begin stepping aside from stock allocations. And if they were investing in most any other asset class or part of the world outside of the U.S., this approach would actually have made a good deal of sense, as many global markets have either thrashed sideways or sold off precipitously since this time.

But not so for the U.S. stock market. Although revenue and earnings growth have been scant at best since the beginning of 2012 in an environment of EPS enhancing low cost of capital and share buybacks, stocks have risen from their 2011 year end close of 1257 to a recent all-time high of 1850. In short, we have seen a +47% rise in the stock market over the last two years based on little other than the hot air of multiple expansion fueled in part by $1.2 trillion in Fed asset purchases. This has understandably emboldened the bulls with an extraordinary amount of confidence as we enter the New Year. Unfortunately, this only adds to the danger for investors once the slumbering bear finally emerges from hibernation, as he may prove far hungrier than usual this time around.

Clearly, the stock market uptrend remains firmly in tact, but as evidenced by the previous two episodes, one can easily find themselves three to six months into a new bear market phase without knowing it until well after the fact. And it is not long after a bear is fully unleashed that what at first looks like a generally harmless pullback and a great "buy the dips" opportunity turns into a cascading -20% to -30% sell-off. And given how much the current market is inflated on Fed stimulus, the magnitude of any such cascade decline has the potential to be far greater than normal.

Lastly, as the previous two stock bear markets have shown, just as the performance of virtually every other asset class other than U.S. stocks in 2013 also demonstrated, is that the "don't fight the Fed" mantra has its bounds and does not hold under all circumstances. And unlike past episodes where Fed largesse helped resuscitate the markets from their lows, the Fed will be far more limited in its capacity to provide market boosting shock paddles the next time around. Maybe stocks will have to fight their way back on their own for the first time in over a quarter of a century. If they do, they will likely do so with lower valuations than they have in the recent past once the Fed put premium is finally removed.

So what are the warning signs that investors should watch to try and escape the clutches of the next bear? For if the market may not necessarily bounce back as quickly in the aftermath of the next raging bear, investors would be well served to step aside in advance this time around instead of getting dragged back down to the bottom for yet a third time since the new millennium.

The following is a basic checklist of indicators that may signal the current bull market has finally passed.

The first is a break below the 200-day moving average on the S&P 500 Index. Any initial breakdown will likely appear benign enough, as it will probably appear to look like the corrections seen in 2010, 2011 and 1998 for that matter. And emboldened market pundits will be chirping about how it will be the "buy the dips" opportunity that investors have been waiting for since late 2012. These same analysts will also be quick to remind investors that those that jumped out during past corrections over the last five years have been punished almost every time for doing so. Thus, the urge to stay in the market will be strong, but discipline will be most important at this stage. The failure to reclaim the 200-day M.A. on the first few retests will be notable, but this will also be consistent with what was seen with recent head fake bears. But if the market fails to break out back above its 200-day M.A. and falls back to new lows, any subsequent retest should be viewed as a potential exit point.

The second is the trend in corporate profits. If earnings growth takes a sudden turn to the downside that accompanies the break below the 200-day M.A., this would provide a potential confirmation signal that the bear market is getting underway in earnest. Of course, the ability to obtain this full earnings view comes with a lag due to the timing of earnings reports, so maintaining a close independent watch on earnings trends (and not the typically overly optimistic projections from many analysts) will be important.

The third is keeping an eye on the liquidity backdrop. The Fed along with other global central bankers have had a "do whatever it takes" bias in support of the financial system in general and the stock market in particular since the bottom of the financial crisis in 2009. Today, it seems as though this focus is shifting, however. China is working to try and drain excess liquidity from their system to quell asset bubbles, the Fed is eager to exit the QE3 stimulus program in which it has been trapped since last summer and the Bank of Japan is getting toward the later stages of its own extraordinary stimulus program. One also gets the sense that global policy makers have come to the realization that juicing the stock market to produce a wealth effect to fuel economic growth is not working and that it is time to try something else. And the increasing dialog about growing income inequality suggests the priority to keep the stock market propped up may be fading away in favor of a new focus.

Lastly, remember that the bullish majority is likely to remain vocally bullish long after the bear market is well underway. The stock bulls have been made extraordinarily cocksure after being repeatedly right for roughly five years now. And it remains the incentive of most equity analysts to speak in support of the stock market. For just as you would be less inclined to buy an automobile from the dealer that tells you its not a good time to buy a car, you may be far less inclined to place your money with a stock manager that is warning of losses in stocks. Such optimistic dialog can be persuasive, particularly once one is trapped in a bear market and is hoping to recoup losses. Unfortunately, the eventual bear market cascades lower only take place once this stubborn bullishness finally starts to evaporate with stock losses doubling or tripling in a matter of weeks. In the end, investors are left with the feeling that they didn't see the bear market coming and are now in so deep that they are left with the awful dilemma of locking in losses or riding it out to who knows when.

This is why a focus on broad asset allocation and a global perspective is so important in navigating the market environment over time, for the recognition that the investment opportunity set stretches well beyond the U.S. stock market to a wide range of different options enables one to look at the prospects of the stock market or any other asset class far more objectively.

The bull market in stocks remains firmly intact. And perhaps the stock market will continue to rise indefinitely. But after nearly five years of steady increases including the past two with little in the way of fundamental support, the risks are climbing that a new bear market may be arriving sooner rather than later. As a result, it is worthwhile to have an escape strategy at the ready for when the state of the market finally turns. For at this stage, it may be far better to be out a bit early than to have stayed a bit too long.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Additional disclosure: I am long stocks via the SPLV and XLU as well as selected individual names.