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The Anatomy of The Bear

Created:
7 July 2008
Written by:
Simon Thompson

I have recently been giving a series of investment seminars and, unsurprisingly, the one issue that keeps cropping up is when this equity bear market is likely to bottom out. My theory on this is quite simple.

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First of all, the extent of the fall in share prices from the peak of the last bull market to the trough of the bear market has to have some proportionality to the gains registered in the previous bull market. Moreover, it is worth remembering that the previous bull market lasted a lengthy 55 months and posted gains of over 100 per cent in the UK and the US (based on FTSE 100 and S&P 500 indices) when the double top in both was formed in October last year. It is therefore unreasonable to expect a bear market to be over in double-quick time, otherwise investing would be far too easy a game to play if it did not cause psychological damage and painful financial loss when markets enter a downtrend.

FTSE 100 downside target

I continue to maintain an intermediate downside target of 5000 for the FTSE 100. This level has great significance being a 50 per cent retracement of the gains made during the 2003-07 bull market and a 25 per cent fall from that October peak. It also fits in neatly with price trends in previous bear markets since The Great Depression (Histrionics, 11 Apr 2008). Moreover, I believe the odds that there will be a sell-off to this level this summer have improved in recent weeks, fuelled by the rampant oil price, the possibility of a bond market sell-off (Goodbye Mr Bond, 4 Jul 2008) and a eurozone earnings recession (Earnings recession, 16 Jun 2008).

It would be ideal if a test of the 5000 level also coincided with a near-term peak in the oil price (Oily Truth, 9 Jun 2008) as that would set the scene for another strong countertrend rally like the one we saw in March through to May. I would be looking to buy into this rally as it would fit with my theories on the US presidential cycle (Presidential profits, 27 May 2008) and Federal Reserve Monetary Policy (Easing into profit, 2 June 2008).

S&P 500 and 200-day moving average

In bear markets the price performance of the US and UK equity markets are highly correlated. So, if the FTSE 100 fell to the 5000 level, the S&P 500 would be trading around 1150 - 20 per cent below its 200-day moving average. That is significant, because research from James Altucher, a partner at hedge fund Subway Capital, shows that if you had bought the S&P 500 every time in the past 33 years when it has fallen 20 per cent below its 200-day moving average, then one month later you would have been in profit. This has happened 34 times since 1975 with every trade a winning one. The last time this occurred was in October 2002. Therefore, this gives confidence that there would be a profitable and tradable bounce in both the S&P 500 and FTSE 100 indices if they fall to the respective levels above.

Countertrend rallies

Remember, too, that countertrend rallies are inevitably sucker punches and bull traps. So, to profit from them, we have to behave like traders and not buy-and-hold investors as ultimately they peter out and share prices retrace the gains made. That is exactly what happened between mid-March and mid-May when the FTSE 100 rallied almost 18 per cent. The index has since retraced almost all those gains, falling by 14 per cent since 19 May.

Admittedly, it is quite possible that the FTSE 100 will not get down to my 5000 target before the second major countertrend rally of this bear market begins. But this is actually good news since the bounce in the market will create another opportunity for us to re-enter short index trades at a later date, safe in the knowledge that 80 years of history indicates that the bear market will not end until the FTSE 100 drops back to the 5000 level at the very least.

In this scenario, a strong rally from the summer lows into the end of the year would create the scene for equity markets to take a climatic hit in early 2009. At this stage I envisage four key drivers for this: post election blues in the US; the oil price resuming its upward trajectory, assuming it makes an intermediate peak this summer; significant corporate earnings downgrades; and a rise in corporate default rates (Goodbye Mr Bond, 4 Jul 2008). Therefore, the higher the markets bounce back later this year all the better, as it will offer scope for us to make even more profit shorting the next down leg.

Trading strategy

I would run profits on our FTSE 100 covered put warrants, SM29, looking for a summer test of the 5000 level on the index (Get shorting, 2 May 2008 - currently showing a profit of 54 per cent). If the target is hit, bank profits on these put warrants and also on the SG Bear Market Accelerator, SN01 (Bear necessities, 14 Jan 2008 - profit of 23 per cent) and buy the S&P 500 index tracker to trade the anticipated countertrend rally (Presidential profits, 27 May 2008). Please note, too, that the FTSE 250 short-listed contract for difference, C433, expires on 11 July and is showing a 55 per cent profit (Bad tidings, 7 Jan 2008).

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