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Rising All The Way Down

10/31/03 09:48:26 AM PST
by David Penn

Are bear market rallies worth the bother?

A funny thing happened on the Nikkei 225's drop from 39,000 in 1989 to its most recent low of about 7,500 in late April 2003. Actually, five funny things happened as 31,500 points — representing a decline of some 80% — were stripped from Japan's largest stock market: The market rallied.

Consider these gains. In 1989, the Nikkei rallied from 28,000 to 33,000 for a gain of 18%. In 1990-91, the Nikkei rallied from 21,000 to 27,000 for a 29% gain. In 1995-96, just as the Standard & Poor's 500 was shaking off its early 1990s doldrums, the Nikkei romped from 14,000 to nearly 23,000 — a 64% gain. The bubble era of the late 1990s also treated the Nikkei quite well, as it advanced from 13,000 in 1998 to just short of 21,000 in 2000 for a 61.5% gain. And, of course, there was the Nikkei's most recent performance: the 2003 bull market that saw the Nikkei climb from near 7,500 to over 11,000 — a nifty 47% run.

In sum, over a period of about 14 years during which the Nikkei lost some 80% of its value, the Japanese index nevertheless featured five distinct rallies during which gains, on average, were 44%.

What a market!

There's a saying about the financial psychology that develops during a deflationary depression such as the one Japan has experienced — at least intermittently — over the past 14-odd years. That psychology consists not only of such axioms as "Neither a borrower nor a lender be," but also gave rise to the sense that stock markets weren't meant for investing (a store of cash underneath your mattress, perhaps next to those illegal gold coins, was all you needed to know about investing . . .). Trading the markets, on the other hand, was considered a worthwhile enough pastime for those whose finances were still intact. The idea of "stocks for the long run" seemed incomparably silly to most people in the midst of a deflationary economic meltdown. But "stocks for the quick flip" likely appeared to be harmless enough.

This look at the Nikkei's performance helps underscore why. Even if you halve each of the returns from the five major bear market rallies between 1989 and 2003, you are still left with excellent returns (approximately 22%) on the invested dollar. Again, that such returns would be obtainable in the context of a crushing bear market is as significant to the permabulls as it is to those who would urge packing up and leaving town as soon as bear season arrived.

LITTLE BULLS AND BIG BEARS

Clearly, it would not have been unreasonable for someone who enjoyed outsized stock market returns in the 1990s to decide to move completely out of stocks once the bear market began in 2000. But while most investors in the 1990s did enjoy huge gains, few saved enough or invested so well that they could retire and live off their investments by the spring or autumn of 2000 when the markets turned south. This meant that while the bull market of the 1990s provided some great starts for many investors, stock portfolios would need to continue to perform well for another decade or so before most of those investors (read: baby boomers) could accumulate a sizable enough sum to live on for the rest of their lives (money manager and radio show host Bob Brinker refers to this sum as "critical mass").

This means that even those who are long-term stock market bears can participate actively in trading stocks during long-term bear markets. Such participation may need to take the form of market timing or even outright intermediate-term position trading. But while it is true that we may be moving from the "return on principal" investment theme and toward a "return of principal" world, it remains the case that those looking to grow their money will have to learn how to do so in the stock market, whether the market is in a bullish or bearish phase. As William O'Neil, founder of Investor's Business Daily, wrote years ago:

It is not enough today to just work and earn a salary. To do the things you want to do, to go to the places you want to go, to have the things you want to have in your life, you absolutely must save and invest intelligently. The second income from your investments and the net profits you can make will help you reach your goals and provide real security.

If the error during bull markets is to believe that every investment is worth making — from mobile grocers during the US dotcom bubble to sun-powered lamps during Japan's bubblelicious equity markets 10 years before — then perhaps the error during bear markets is the conviction that everything is worthless, primed to underachieve or, worse, to defraud. Imagine if some of those Depression-era investors who were cautiously dipping into and out of the stock market in the early 1930s had instead made bona fide investments in key corporations. Borrowing from the same sort of risk management that they'd been accustomed to as stock traders, most of these Depression-era investors still would have come out far ahead of where they actually did.

MARKET TIMING AND TRADING DISCIPLINE

Nevertheless, the point remains that rallies during bear markets — whether they are examples of true value investment or "merely" instances of shrewd, opportunistic trading — can be profitable opportunities for alert, contrarian market timing. These opportunities are all the more significant for those who are unable to — or uncomfortable with — selling stocks short. Whether such sentiments are extensions of a personal philosophy about selling short, or are the result of the way a given investor's finances are structured (for example, mutual funds and 401(K)s), the fact of the matter is that many people who look to make money in the stock market are prepared to do so only from the long side. As such, these timers, investors, and traders must look for exceptional moments of value — often appearing in the marketplace as panic, fear, or disgust — during which to strike.

Brinker, who coined the term MOABO (an acronym for "mother of all buying opportunities") to refer to the stock market in the early 1990s as equities began to rebound in the wake of former Iraqi dictator Saddam Hussein's invasion of neighboring Kuwait, defined "market timing" as:

. . . The effort to base investment decisions on the anticipated direction of the market. If equities are expected to decline in price, the market timer may elect to hold a percentage of the portfolio in cash reserves or other fixed-income obligations. Timing may be based on fundamental or technical conditions, or a combination of these factors.

These fundamentals may be price/earnings ratios or book value, dividend yields, or insider buying and selling behavior. Technical conditions could include 50- and 200-day moving averages, the volatility index (Vix), long-term trendlines, or even simple pattern recognition. Nevertheless, one of the key aspects about market timing is that market timers — unlike some traders — are initially concerned with market direction, and use it as a key indication as to how much stock exposure (if any) is recommended.

Unlike traditional buy-and-hold investors, market timers are thoroughly comfortable with holding cash or, as Jim Rogers of Investment Biker fame has said, "doing absolutely nothing until there is something to do." Such an attitude toward the markets can require the patience of Job — something many traders (and investors, for that matter) have a difficult time pulling off.

However, bear markets afford investors and market timers with the opportunity to do this very thing. Money manager Marc Faber, whom I've quoted before on this point, notes that an investment allocation shift at the beginning of each decade since 1970 (gold in 1970, Japanese stocks in 1980, US stocks — especially techs — in 1990) would have been all the market timing that any investor over the period would have needed.

A SHORT HISTORY OF THE HISTOGRAM

Many technical tools/indicators are rejected by traders because they provide signals that, while effective and accurate, are too infrequent for active trading. Some of these indicators also seem less effective over longer periods of time. One indicator, however, that is especially adaptable to the longer-time frames of the market timer or position investor — or simply someone looking to exploit temporarily excessive weakness and pessimism in a down market — might be the MACD (moving average convergence/divergence) histogram indicator. One particularly strong advocate of the MACD histogram is Alexander Elder. In his book Trading For A Living, he notes that "MACD-histogram works in any time frame: weekly, daily, and intraday. The signals of weekly MACD-histogram lead to greater price moves than the daily or intraday indicators." Elder acknowledges that this "principle" is applicable to most indicators, but his enthusiasm for the MACD histogram is clear:

MACD-histogram offers a deeper insight into the balance of power between bulls and bears than the original MACD. It shows not only whether bulls or bears are in control but also whether they are growing stronger or weaker. It is one of the best tools available to a market technician.

And later,

MACD-histogram gives two types of trading signals. One is common and occurs at every price bar. The other is rare and occurs only a few times a year in any market — but it is extremely strong.

"A few times a year"? "Extremely strong"? Sounds like a perfect combination for a market timer, intermediate-term investor, or position trader. In addition, because this group of market players inherently looks to make strategic entries at or near major market turning points, the MACD-histogram provides a particularly effective clue to catching those turning points. Again, Elder comments:

When the current bar is higher than the preceding bar, the slope is up. It shows that bulls are in control and it is time to buy. When the current bar is lower than the preceding bar, the slope is down. It shows that bears are in control and it is time to be short . . .

Elder suggests buying the market when the MACD histogram stops falling and ticks up. When the MACD histogram stops rising and ticks down, Elder advises going short — or, in the case of an investor, moving into cash. Interestingly, Elder is more impressed by this aspect of the MACD histogram on weekly charts as opposed to daily charts, which also fits in well with the longer-term focus of the market timer or intermediate-term investor.

It may also be significant to consider using the MACD itself as an indication of the sort of extremely oversold/extremely overbought conditions that lead to dramatic moves to the upside or downside, respectively. Consider the weekly chart of the S&P 500 that focuses on the market bottoms in the spring and autumn of 2001 (Figure 1).

Figure 1: With the MACD in deeply oversold territory, upticks in the weekly MACD histogram enabled shrewd market timers and position traders to buy at or near the lows.

In both cases, there were numerous instances during the spring and autumn 2002 declines where a trader or investor might have decided that the market had moved down "enough," and bargains were to be had by committing capital now. However, the weekly MACD histogram provides sound signals not of when the market has stopped going down, but more important, when the market has started going up.

Note first the spring decline. The S&P 500 in September 2000 rallied after what most people at the time believed to be just another "buy the dip" opportunity in a market that had been on a tear for the past five years. However, the market moved down from the September highs and, after six months of declines, was down some 20%.

By mid-March 2000, the MACD had become as oversold as it was overbought back in the spring of 1999, and the histogram, which had been ticking lower and lower each week, finally ticked higher on April 13. At that time, the S&P 500 stood at about 1184. Two weeks later, the fast MACD line crossed above the slow MACD line as the S&P 500 closed at 1253 for the week — a 69-point advance from the point where the histogram bottomed and ticked higher. The histogram continued ticking higher, ticking above the zero line during the week of May 4 and making its high tick for the move at a weekly close of S&P 500 1277 for the week of May 25.

Another example comes in the wake of the autumn decline in 2001. The S&P 500 fell from the spring 2001 highs of approximately 1277 to an autumn low of 945 in late September. With a low just under 945 in the week of September 21, the MACD histogram bottomed that same week and ticked higher the following week — a week that closed with the S&P 500 at 1041. By the time the MACD histogram peaked above the zero line and ticked lower during the week of December 14, the S&P 500's weekly close was 1123 after climbing as high as 1174 the week before.

MACD AS PART OF THE TIMING MIX

As powerful as the MACD and the MACD histogram are, they are probably best used as components in a market timing system, as opposed to being the entirety of one. Other methods, including fundamental, market valuation, and even other technical indicators such as long-term moving averages, can and should be part of a suite of tools market timers use to gauge when to maximize their exposure to the market — as well as when to pull back and preserve capital for a better opportunity. Using shorter-term time frames such as the daily time frame in concert with the weekly MACD and MACD histogram is just one worthwhile strategy to make the most of these countertrend moves.

David Penn may be reached at DPenn@Traders.com.

SUGGESTED READING

Elder, Alexander [1993]. Trading For A Living, John Wiley & Sons.

Nassar, David S. [2001]. Rules Of The Trade, McGraw-Hill.

Weinstein, Stan [1988]. Secrets For Profiting In Bull And Bear Markets, Dow Jones-Irwin.

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David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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