Bear Market vs Recession
In the last blog post we talked about some of the big trades we helped customers nail during the first sustained rally in the 2022 bear market.
SWAV was the most impressive story, long-term trend, consolidation pattern and earnings report/outlook combination. It shot up about 30% within about 3 weeks of reaching our entry trigger. More importantly, it held a 1.5% stop loss below the technical entry point which is common with our bigger winners.
We pointed out the earnings flag in the last blog post on SWAV. Those using our earnings flag strategy were able to get in after the article was published and are still up on the trade even though the Nasdaq tanked 4% on Friday.
A positive sign for the market actually when top leaders hold up like this.
Bear Market vs Recession
Last time we discussed how long-term bear markets often have 3 to 5 large corrections. Not just 1 like we have seen so far this year.
Shorter-term bear markets tend to have only 1 large correction of about 20% to 30% and last 6 to 9 months before trending into or near the highs.
So what is the difference historically between around a 50% haircut on the S&P 500 (or more) in a long-term bear market and just a 24% drawdown?
You guessed it. A recession. A recession tends to make bear markets longer with a steeper drop in the market averages.
The most severe drops tend to occur during the third and fourth large corrections toward the end of the bear market as margin calls unfold for weeks or months. These big drops tend to occur a year or more after the prior all-time high on the S&P 500.
So far there is a good argument that this is “just” a technical recession. We have seen 2 quarters of economic contraction so far on a real basis but have not seen an increase in unemployment.
However, unemployment is always a lagging indicator and it may be just a question of time before the unemployment rate increases. The Fed kind of told us that yesterday in Jackson Hole mentioning the dreaded “pain” that is likely coming. (Its funny how “Jackson Hole” kind of rhymes with an expletive :))
That being said, we have a historic low unemployment level currently so there is room before we even get to 5% or 6% unemployment.
Leading indicators for unemployment are showing that unemployment is likely to increase next month. However, first time unemployment claims had a positive surprise again last week. So there are some mixed signals here to be sure. At least for now.
The next month or so of weekly claims and the monthly jobs report will be critical to watch along with any financial meltdowns starting in emerging markets, crypto, big hedge funds, China or Europe.
Bear Market History
“History doesn’t repeat itself but it often rhymes” is a famous quote. If Mark Twain did indeed say this, he probably would have been a good trader in the age of the Fed.
But what crushes bull markets eventually is not really the Fed, not money printing, not some “black swan” event…..
Its inflation. Its the natural result of a long economic cycle. Eventually you get to the point where demand has been fulfilled, the employment market becomes very tight and you end up with the resulting inflation.
The inflation ends up reducing demand, whatever led the economic growth cycle to begin with becomes saturated and you eventually get a reduction of that demand and GDP. The Fed helps this downturn along to try and avoid a wage/price spiral which ends even worse.
Of course, they hastened the cycle to move along faster to begin with by lowering rates and buying a lot of bonds.
So the fact we have inflation not seen since the early 1980s tells us that a severe recession is more likely. The inflation could subside quickly which later increases demand again to renew the cycle, but the technical recession is already here.
High unemployment is the final shoe to drop. We may not see severe increases in unemployment until late this year and early next year. Or, only a modest increase which is the best case one would think.
The 1969 to 1970 Bear Market
Its interesting to compare the current market environment with past long-term bear markets.
The 1969 to 1970 bear market is the last time we switched quickly from a period of very low inflation to a period of very high inflation. The downtrend in the market lasted about 1.5 years from the high to the low and took more than 35% off the S&P 500. The US debt to GDP ratio was also about 35% versus 128% today.
The bear market had 4 legs lower over 1.5 years with the final leg much larger than the prior ones. After the third bear market rally, the market dropped more than 20% quickly. It then rallied in the back half of 1970 to end the year slightly higher but still well below the all-time highs.
The actual recession started in Q2 of 1969 and lasted through 1970.
This was followed up with multiple bear markets over the next 11 years as the S&P 500 moved in a large sideways range more or less for about a decade. The lead up to the Paul Volcker dovish pivot (after crushing double digit inflation) kicked off a 20 year period of returns we may never see again. The S&P 500 averaged over 18% per year through both the 1980s and 1990s.
The next bear started in 2000.
2000 to 2002 Bear Market and Recession
The 2000 to 2002 bear market was led by the most aggressive area of the market – the Nasdaq. This is often the case.
The Nasdaq crashed in March of 2000 and the S&P 500 peaked later that year. The Nasdaq peaked late last year with aggressive growth stocks peaking well ahead it. The S&P 500 peaked at the beginning of 2022.
Again, inflation expectations triggered the Fed to raise rates in 1999 well ahead of the slowdown. It takes about 6 months or so for the rate hikes to move through the economy and have a significant impact to slow demand and lower inflation.
The Fed then notes the slowdown and usually cuts rates into the real recession before it starts. The market usually peaks a little ahead of the recession which started in early 2001 in this case after the S&P 500 peaked in September of 2000.
In the 2000 to 2002 bear market, the real crash for the S&P 500 occurred late in the bear market which is usually where the real crash occurs. The S&P 500 dropped about 34% from March 2002 to the July 2002 low. That is 34% in just 4 months on a major, diversified large cap index.
In comparison, in 2022, during what could be just the first leg lower in another long-term bear market, the S&P 500 dropped only 24% from high to low in 5.5 months.
So the final leg late in a bear market normally sees a larger crash that occurs more quickly.
The Financial Crisis Bear Market
The same general cadence occurred during the financial crisis bear market where the S&P 500 peaked in late 2007 and bottomed in March 2009. The third leg lower in late 2008 was the crushing one where the S&P 500 dropped about 44% in just 4 months.
So its the third leg lower that is the largest in most cases. From that low the market generally trades in a wide range for about a year or more, often making a new low along the way, before really trending higher.
The 2020 bear market was more of an initial pandemic panic and large correction. It was over about as quickly as it started and was just a reflection of the uncertainty revolving around the pandemic and the strong lockdown measures that shut down business.
The S&P 500 fell over 30% in about a month and then was back above the 200 day moving average within a couple months on the back of record stimulus from the Fed and Washington.
The important point is that the worst drops for the S&P 500 tend to occur late in a long-term bear market. The 2020 bear market was not a long-term bear market.
Its a big question as to whether this is just a “growth scare” or a long-term bear market full of hedge fund blowups, emergency measures, countries collapsing, bad morning coffee or other bad events. (Hey, you have to somehow find some humor when thinking about how bear markets play out) 🙂
What to do Next
Again, when trading, we play the market we have not the one we expect or want. If the market is trending higher but well off the highs, we still look for the best long plays like ENPH and SWAV a few weeks ago. If the market is trending lower, we look for more shorts as we did for customers of the daily alert during the first half of the year.
The key thing we are looking for to begin preparing for a large third leg lower is to see if the June lows hold. If the S&P 500 gets below the lows and hangs out there around and below those lows for a few weeks, the market is acting like an eventual 60% S&P 500 haircut and we will be preparing for the third leg.
Again, for investors, they would likely just stay the course and earn extra cash to deploy after the third or fourth leg lower. These tend to be fantastic buying opportunities.
There is an argument to be made that this is actually the third leg lower starting already. Some might say the first leg lower ended in March and the 2nd ended in June. This would be a much faster tempo than prior bear markets but is a possibility.
Debunking “Bear Market Rallies”
A lot of talking heads talk about how bear market rallies are some of the best days in the market! How could you miss them? Its really frustrating to see this lack of transparency.
What they do not tell you is that bear markets also have the worst days for the market. Only they have greater magnitude on average to the downside than the up days. Its a bear market going lower after all.
Most people will hear that advice, jump into a bear market rally only to find out the next leg lower in the bear market is far worse. Nothing wrong with that for long-term holds but you have to realize that sometimes it takes five years or more to get back to even when buying early in a bear market.
Many stocks will never come back. Leadership tends to shift in the next bull market.
We focus our efforts on swing trading, however. We want to focus our energies on the best long strategies during sustained market uptrends and the best short strategies during market downtrends within a long-term bear market.
The Now Infamous 50% Retracement Rule
Just when the recent rally was becoming extended, talking heads were busy on TV telling everyone about the “50% retracement rule” as the S&P 500 was retracing over 50% of the losses from high to low.
In a nutshell, this rule states that once you retrace more than 50% off the highs, the bear market is essentially over.
After they were declaring the bear market over, the Nasdaq suddenly dropped 7% over the past several trading days.
Well, in 2001 after the first leg lower of a long-term bear market for the S&P 500, the S&P 500 retraced well over 50% of the first leg lower. Right afterwards, the S&P 500 started to slide in its 2nd large leg lower that took out the prior lows.
Chart courtesy of StockCharts.com
Again, more than a year later, it entered the crushing third leg lower where the S&P 500 dropped 34% in just a few months. This 34% drop started from a level well below the 50% retracement of the first leg lower as seen on the chart above.
A better rule is what we will call the 2/3 rule. If the S&P 500 retraces 2/3 of the losses in the first leg lower and holds in that area for a couple weeks and then moves above the prior swing high, then historically we can say that is when we are more likely in the clear longer-term.
Anything could happen, of course, but that would be a bullish sign where many long trading strategies often have higher win rates historically.
But, again, as swing traders long and short we can trade both the downtrends short and the sustained rallies in a long-term bear market more confidently.
Meanwhile, investors should probably look out over the next five years or more and just take advantage of the large legs lower in the market to add once the market starts to stabilize again after the selloff.
When investing, just realize that the third and fourth legs lower are generally worse when we have a bear market and significant recession. Also, we do not know for sure who the survivors will be if we see a full blown recession.
What We are Swing Trading Now
The important thing we do during a correction and/or bear market is manage our risk. Its a time to really raise the bar for what an ideal trade is, hold more cash, take less risk per trade and make sure we are ready with a great watch list once we see the signs that the next sustained market uptrend is starting.
Stocks like FSLR, ENPH, WOLF, SNOW and others could set up strong consolidation patterns in the weeks ahead. These stocks had strong earnings reports and have other good tailwinds.
If the S&P 500 retraces 2/3 of the losses and holds those levels for a couple weeks and turns higher, we want to watch these and our favorites for good technical entry points. That kind of price action from the major indices could finally break the back of this bear market and show us good signs that we are not heading into a multi-year bear market.
Explosive Stocks we are Watching for the Weeks Ahead