A primary worry among many stock investors today is that the long running bull market may soon come to an end. At the heart of their concern is exactly what lies beyond the bull market peak, as many worry that the subsequent decline into the next bear market could quickly become swift and severe. But history has shown that the transition from a bull market to a bear market is often a gradual and drawn out process filled with rallies and correction that plays out over an extended period of time. In short, bull markets die long slow deaths, and it is this prolonged dying process that causes so many investors to find themselves unwittingly trapped in the next bear market long before they even realize it.
Bear Markets Are Never A Straight Trip Down
What makes the demise of a bull market and the onset of a bear market so dangerous is that the transition process is not dramatic. Instead, it begins subtly and slowly evolves and accelerates over time. A reflection on the past two major bear markets since the start of the millennium highlights how a bull market is gradually laid to rest and a new bear market is released. And for those many investors that have declared their intent to use the next -10% dip as a prime buying opportunity to ride the next leg higher in the stock market (NYSEARCA:SPY), this strategy may prove perilous in the end.
The end of a bull market often begins with the relatively modest initial correction. During the past two market peaks in 2000 and 2007, the decline began with a relatively brief pullback in the range of -9% to -11%. But markets did not continue their descent into a full-fledged bear right away. Instead, they quickly bottomed and rallied smartly for the next few months. This initial bounce helps lull the bullish investor into further complacency. After all, they have been conditioned to the fact throughout the bull market run that advancing to fresh new highs ultimately rewards buying all dips, and it initially appears that such an approach is being duly satisfied.
But something happens along the way. Instead of breaking out decisively to new highs as they have done so many times in the past, the rally stalls. During the past two bear markets, this has taken place essentially at the previous high. Stocks subsequently rollover and enter a new descent. In the past two bear markets, this included another round of -10% to -12% declines.
Still, all seems well to the bullish investor. Despite the unexpected pullback, they have returned to their recent entry point where they initially bought the dip. And during the last two bear markets, stocks began to rally again in quickly posting a +7% to +8% advance. But the spurt higher abruptly ends at levels that are now below previous highs. And the next correction that follows tacks on another double-digit decline in the -12% to -14% range.
Suddenly, the bullish investor is now roughly six months into their position after buying the initial -10% correction and is now showing a loss. Of course, the long running bull market has taught this investor that patience is rewarded. After all, everything still looks like nothing more than a consolidation of recent gains. The thinking still goes that it is only a matter of time before stocks break out once again.
Unfortunately, the last two bear markets have proven this thinking wrong. Stocks post another strong but brief rally in the +6% to +9% range before rolling back over and falling again. In 2001, stocks went on to drop by nearly -20%. In 2008, stocks fell by -9%. But in both cases, investors were left even further underwater in their positions following these declines. Once again, another rally arrives to assuage investor concerns. In 2001, stocks nearly entered into a new mini bull market by jumping +19% and effectively erasing the previous correction. The same was true in 2008, as stocks bounced by +12% following the demise of Bear Sterns in March through mid May. Finally, the bullish investor declares, we are back on track to the upside and we will recover the recent losses sustained during what still appears to be a period of healthy consolidation for stocks.
Then the lights start to go out. At this stage during the past two bear markets, stocks post another double-digit decline, with losses that are greater than those that came before. In 2001, stocks shed -26% through the summer up through the aftermath of the September 11 terrorist attacks. In 2008, stocks dropped by -15% also through the summer as gasoline prices exploded higher.
All of the sudden, investors find themselves with declines in portfolio value ranging from -20% to -35% that have been sustained in fits and starts over the course of a year. It is at this point that they first fully realize that the rally to new highs they had been hoping for are not going to materialize and that they are instead in the clutches of a bear market. But at this stage, the bullish investor typically concludes that it is too late to get out. The market has already sustained a meaningful decline and the thinking goes that it does not make sense to lock in losses now since the bear market may soon be over. Instead, it is time now to hold positions under the notion that since the market has already gone down so much already, surely it cannot go down much further. Moreover, all of the values that seemed so elusive during the bull market are now looking much more attractive. Time to hang in there and ride it out.
Regrettably for the now beleaguered bullish investor, it has been at this stage of the past two bear markets where volatility explodes and the major losses are sustained.
In 2001, the outlook is initially promising. Stocks enter into a mini bull market with a +21% advance into early 2002 and hold these gains into the spring that year. It seems that the worst may have finally passed. Then suddenly the market drops by another -28% into July 2002 before starting to thrash violently with a short mini bull run quickly followed by yet another -19% drop that wipe out the previous bounce and mark the bear market lows for the cycle in October 2002. Stocks over the next six months struggle to regain their footing, but the once bullish investor is left with losses in excess of 50% if they did not capitulate under the stress and sell during the extreme turbulence.
In 2008, the bounce was short and fleeting at just +7% into August. It was then followed by the -35% descent that included the collapse of Lehman Brothers along the way. And just like during the previous bear market, it was at this stage where the extreme volatility ensues, with a brief +19% rally quickly negated by another -25% decline that was then partially offset by a +24% gain followed by the final break lower to the final lows in March 2009 that included declines of -14% and -23% over a very short period of time. Once again, investors are left with losses well in excess of 50% assuming they had the fortitude to continue holding during the peak of market violence.
The Danger Of The Quietly Prowling Bear
All of this is why the end of bull markets and the onset of bear markets are so dangerous for investors. It is not at all because they suddenly appear with a dramatic growl at a bull market peak. Instead, it is because it is quietly and slowly trapping market participants in its clutches by masquerading as the previous bull market for months before finally revealing itself as a bear.
Despite the extreme risks, the traditional characteristics of a bear market bode well for investors for the following reason. Once the market peaks, you will very likely have time to get out relatively unscathed. But the key to being successful with such a transition is knowing exactly the signs to look for that indicate that the bull market is finally ending and no further new highs are in the offing.
Thus, now is not the time for complacency. If the recent -4% correction eventually continues to become a -10% correction, investors may wish to at least take pause before jumping into the market with both feet. For the clutches of a bear trap may be waiting as their feet hit the ground on any such move.
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.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long stocks via the SPLV and the XLU as well as selected individual names. I also hold a meaningful allocation to cash at the present time.