A DISSECTION OF THE 4 PHASES IN A CORRECTION OR BEAR MARKET CYCLE
Almost exactly one month ago, I described the 4 phases of a bull market cycle. My reason for writing the article was to warn market participants of the impending disaster that tends to strike right around the time a certain class of investor (termed "phase 4" investors) becomes involved in the financial markets.
Since the time that article was written the QQQQ is down over 7% and the SPY is down 5%. I mentioned 3 stocks in the article that invariably tend to attract the euphoric "phase 4" class of investor. All of the 3 names are down significantly over the past month, with FNSR suffering the worst out of the trio with a 50% (no, not a typo) decline over the past month.
Given the types of declines we have seen in many of the phase 4 names, the astute investor has to be wondering if the market has done a terrifically expedient job of rinsing the excessive optimism out of the market? It's a valid question that deserves to be explored.
Just as a bull market has 4 phases, a bear market or correction cycle will have various phases that tend to frighten different types of investors. By watching the types of investments that are being liquidated by these investors during the various stages of a bear market or correction, one can make somewhat accurate judgments as to whether unwarranted pessimism has created an opportunity for the market to create a sustainable bottom from which a rally may develop.
Judging the phases of a bear market or correction cycle is remarkably more difficult than judging the phases of a bull market cycle. I believe this is due to the fact that fear causes more emotional reactions in human beings than does greed. The more emotional a move in the market becomes, the more difficult it becomes to predict and the more chance it has to overshoot any reasonable technical targets. The loss of ones hard earned dollars seems to inflict greater emotional reactions than the greed driven ecstasy of making enough money to buy a new Jaguar. Make sure to keep this in mind as we discuss the various phases of a bear market or correction cycle.
Phase 1 (beginning of bear market or correction cycle) -- Investors ignore even the most obvious signs that the market is turning around. Sentiment surveys, put/call ratios, COT reports, negative divergences, the appearance of phase 4 bullish investors. Every warning sign is ignored. Investors are eager to buy the dip in their favorite stocks, as they feel that the market is set to turn back up. The most speculative companies begin experiencing unusual volatility. The general market averages are not immune from the volatility, as their daily ranges expand significantly along with the volume that accompanies the range expansion. Confidence in the market remains high. Bulls parade on CNBC touting the benefits of owning stocks. Financial anchors, analysts and fund managers appear jovial and friendly whenever making media appearances.
Phase 2 (early recognition of a bear market or correction cycle) --Investors begin entertaining the possibility that the averages may be in the process of a correction. Questions about how long it will take the market averages to make new highs begin making their way into the minds of investors. Bullish participants begin taking a second look at the various warning signs that signaled an impending correction. Concern is expressed through the consideration of taking profits on a portion of the portfolio before those profits vanish. High-beta names across various sectors begin gathering momentum to the downside as speculative investors move back into cash. Investors begin looking at support levels for the major averages. Active traders begin considering short positions rather than long positions. Institutions are in the process of raising their cash levels, causing weakness in the large and mega-cap space. Bulls continue parading on CNBC. Their subject matter, however, has changed to how beneficial corrections are to any sustainable bull market. An occasional bear makes an appearance, seeming timid and unsure.
Phase 3 (full recognition of a bear market and belief in it) -- Notice I said bear market and made no mention of correction cycle. In phase 3, the term correction cycle no longer applies. The very fact that full recognition of market weakness has occurred means that the bull market has now entered bear market territory. At this juncture, participants begin turning away from stocks that increase their risk profile even slightly. Large institutions turn to utilities and health care stocks as a means of preserving capital. Analysts begin talking dividends, yield, fixed income. Aggressive sectors such as technology are shunned by investors and institutions. Put buying becomes rampant. Technical support levels begin losing their influence, as fear begins taking precedence over rationality. Bears begin appearing with regularity in the financial media. CNBC anchors appear very serious and unwelcoming. Bullish pundits are greeted with some hostility.
Phase 4 (fear and panic) - All sectors begin experiencing fear driven declines. Volume increases exponentially as the daily ranges for the various market indices expand dramatically. Intra-day volatility becomes so rampant that it deters a majority of market participants away from the equity markets completely. Investors that remain in the market cannot stand the losses and simply want the comfort of cash. Wall Street analysts, fund managers and anyone with a suit and a tie for that matter is regarded as criminal. Investors begin expressing their feelings of fear, regret and panic to each other on subways, in coffee shops and at the office. Nouriel Roubini, Marc Faber, David Tice and Bill Fleckenstein are regarded as greek gods on CNBC and in various financial publications. Bob Prechter makes a call for Dow 600. CNBC anchors begin appearing disheveled, often times talking over one another. Utter hate and disgust of the financial market sets in.
The brutal part of any bear market cycle is if and when the 4th phase arrives. Many bear markets reverse before going into a 4th phase. Periods in the market like 2001-2002 and 2008 are clear examples of phase 4 moves in a bear market. They lack any attention to rationality and should be avoided at all costs.
With respect to the current march of the bears, I believe that we entered phase 2 of this correction cycle last week. The general market averages seem more than willing to hold support, which is picture perfect behavior for the 2nd phase of a correction.
The focus of investors, however, should be on whether the markets want to enter phase 3. Should the SPY and QQQQ hold onto their recent lows, simply chopping around these levels for the next few months, then the pain of entering a bear market may be avoided by the bulls.
Warning signals of entering phase 3 will be:
- Lack of regard for support levels
- Further deterioration in former market leaders
- A consistent pattern of substantially greater volume on down days than up days.
As always, no matter which side of the trade you choose, watch your risk and the reward will take care of itself.
