The Three Stages of a Bear Market

Which stage are we in now? SPECIAL OPPORTUNITIES [The Oxford Club Special Opportunities]( The Three Stages of a Bear Market Jonathan Mead, Research Analyst, The Oxford Club [Jonathan Mead] I was recently reading about bearish market psychology when I stumbled across Wall Street veteran Bob Farrell. Starting at Merrill Lynch in 1957, Farrell accrued more than 50 years of investing experience. He studied technical analysis after realizing there was more to stock prices than a company's balance sheet, and he eventually became an expert in market psychology. Understanding market psychology is tricky, but it's essential in volatile market environments like we're seeing now. So to help us gain a general understanding of market psychology, Farrell established his [10 trusted rules]( which are still widely quoted today. The rule that stands out to me is the one that characterizes the three stages of bear markets. It states, "Bear markets have three stages - sharp down, reflexive rebound and a drawn-out fundamental downtrend." And we can see those exact three stages in the following chart of the S&P 500 Index during the housing market crash in 2008... [S&P 500 Housing Market Crash]( The first stage of a bear market occurs when the fewest see it coming: the initial sell-off. This is usually a drop of 10% or more, and it marks the beginning of a new trend. A sharp decline can have various catalysts. Most recently, the major indexes began selling off in the first week of 2022 as news came out that Federal Reserve officials were discussing more aggressive rate hikes. Following the January sell-off, markets proceeded to become extremely volatile as the threats of war and recession loomed over the global economy. The high-volatility environment we're seeing now has been a common precursor to market crashes in the past and could be hinting at the next major correction. The second stage of a bear market generally occurs when investors become emotional and upset over their losses from the sell-off: the reflexive rebound. Triggered by events like positive news headlines or institutional short covering, reflexive rebounds are identified by a reversal into an uptrend in stock prices following a sell-off. As investors chase initial losses, greed causes many to "buy the dip" and increase their risk appetite in the hope that the sell-off is finally over. These "relief rallies" are generally dangerous in bear markets because of their tendency to trap bullish investors, resulting in larger losses for those trying to time the bottom. The third stage of a bear market occurs when focus shifts from news headlines to larger economic concerns: the drawn-out fundamental downtrend. While news headlines are effective at moving markets in the near term, underlying economic issues are the true drivers of longer-term market direction. Whether it's high interest rates, supply chain bottlenecks or extreme valuations, serious economic concerns are the main causes for selling and can eventually result in a recession. So that brings us to the big question: If we're in a bear market, which stage are we in right now? Well, we've already seen a sharp market sell-off, with oil and commodities prices reaching 2008 levels and a geopolitical conflict that is aggravating supply chain concerns. Recent market volatility can be attributed to the news headlines, but these headlines have been a distraction from the larger economic issues. There are multiple concerns right now that may indicate a long-term fundamental downtrend... - The Fed is about to hike interest rates, which will slow the economy. - Oil prices are the highest they've been since 2008, and Americans are already feeling the impact at the pump. - As of this writing, the inflation-adjusted [U.S. Shiller price-to-earnings ratio]( for the S&P 500 is the highest it's been since the dot-com bubble at 35.01 - a major red flag when assessing valuation. And perhaps the greatest concern is the spread of the 10-year and 2-year Treasury bonds. When spreads approach negative values, it's a sign of severe weakness. In the chart below, notice the periods when this spread turns negative... [10-Year Minus 2-Year Treasury Yield Spread]( Each instance of a negative spread precedes a recession. These market conditions lead me to believe that markets are in a reflexive rebound, or stage two of a bear market. There have been two brief rallies in the S&P 500 since the January sell-off began, but a clear downtrend has been established, and it's unlikely that the rebounds we'll see in the near future will reverse this downtrend. With gas prices continuing to soar and interest rate hikes approaching, consumers will cut back on spending. And it could be months or even years before we return to a bull market. Because of these serious economic concerns - and with inflation sitting at 7.9% and rising - this is not the time to be taking unnecessary risks. Bob Farrell would surely advise against buying these near-term dips. Right now, the name of the game is preserving capital, and those who are successful in weathering this storm will enjoy great financial reward after this mess is over. Good investing, Jonathan P.S. Even though there's a bleak outlook in the markets for the moment, that doesn't mean there aren't opportunities for investors. 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