Talk about a rough start to the 2016 stock market investing year!
Investors are afraid that a bear market is upon us. Truth is that there is no reason to be afraid, even if a bear market appears.
This article will explain exactly what a bear market is and what you need to know not only to survive but to profit from it.
First, let’s take a look at what has happened so far this year for perspective.
The stock market ended the first 2 and a half trading weeks of 2016 with a steep sell-off.
All three major stock indexes – the Dow, the Nasdaq composite and the Standard & Poor’s 500 – are now in what’s known as a correction, or a drop of 10 percent or more from their recent peaks.
The fundamental reasons for the selling is three pronged.
First, alarm over a slowdown in China.
Second, the plunging price of oil to its lowest level in 12 years; and thirdly the climbing interest rates.
The Associated Press Quoted a regional investment strategist at a U.S. Bank “Oil is the root cause of the selling. People are uncertain, and when they’re uncertain they’re scared.”
Crude oil has plunged below $30 a barrel from a high of over $100 during the summer of 2014, destroying energy company profits.
Bearish pressure also has come from economic numbers. The Federal Reserve said U.S. industrial production, which includes manufacturing, mining and utilities, fell in December for the third month in a row. While another government report indicated U.S. retail sales dipped last month.
What Exactly Is A Bear Market?
The official definition of a bear market is a 20% decline from the major index highs.
Is This A Bear Market?
Taking a look at the Dow Jones Industrial Average, the high was hit in June 2015 at 18351. A 20% drop or 3670 points will lead us to 14681 on the Dow as the start of a bear market.
Right now, we are still 1000 points away from an official bear market in stocks.
During bear markets, stocks often stage sharper rallies than they do during bull markets. These rallies can be used by bullish traders to capture profits despite the overall selling. However, it is critical that you remain nimble and alert with all positions placed during bear markets.
Long term investors need to remember that during every 15 year period since World War 2, stock market investors have made money.
History has proven that bear markets can be triggered by a variety of factors. There is no single cause of a bear market. Sometimes it is a geo-political event like the Iraqi invasion of Kuwait in 1990 or the 1973-74 bear market caused by the formation of OPEC.
Internal economic factors can also trigger the bear. In 1982, the Federal Reserve started jacking up interest rates to fight inflation and a bear market in stocks was the result.
Other times, like we witnessed in the tech crash, simple overvaluation of stock prices can result in massive selling turning into a bear market.
Today, should a bear market be triggered, it will likely be from a combination of the Federal Reserve rate increase, international pressures, and profit taking from the long term bull market.
Why Is This Sell Off Different?
Interestingly, every other bear market has started with either rapidly climbing interest rates and/or a sharp slowdown in the U.S. economy, or a black swan economic market shock.
While no one can predict a black swan shock, none of these fundamental bear market triggers is occurring. While no one can forecast the future, we believe the signs are that a bear market will not occur from the recent correction.
First, the Federal Reserve will continue to exercise extreme discretion with rising interest rates. The Fed is very cautious about the effects of higher rates and takes these negative effects into consideration during its every change.
Secondly, the U.S. economy is growing. It’s not major growth, but 2% to 2.5% a year is completely acceptable
Most critically, companies are still hiring. Job numbers were increased by 2.3 million in 2015. This is quite the opposite of what happens during a true economic slowdown.
The Truth About China’s Fears
Make no mistake, China’s slowdown weighs heavy on the U.S. economy. But what is the truth about China? Ex hedge fund manager and investment book writer, James Altucher, has an intriguing view on China.
Altucher states,
China growth is slowing. So the Wall Street Journal, which I used to write for, is saying “Chinese economy reeling”.
Oh my god. Please please please. Stop that.
China is GROWING. It used to grow 10% per year because it was communism and 2 billion people were farmers.
Now it’s “going down” to 7%.
Horrors! The world is over.
But what if it continues?
Who cares!?
Guess how much we “sell” to China per year. I put “sell” in quotes because newspapers make it sound fancy and say we “export”. BS economics writers.
Less than 1% of our Gross National Product is sales is to China.
So even if CHINA DISAPPEARED COMPLETELY the US would still have a growing economy.
Oh, did I mention China is not disappearing. It’s GROWING. At a faster rate than the United States.
While this may be an extreme view, it succinctly explains why the market has overreacted to China’s woes.
Always remember, the main catalyst of the U.S. economy is Americans purchasing goods and services.
There are very positive signs Americans are spending. Auto makers just sold the most cars ever in 2015, setting an all-time record.
“We expect domestic demand in the U.S. to remain reasonably healthy — a very important variable for corporate revenue growth,” says David Donabedian, chief investment officer at Atlantic Trust.
What If The Bear Really Does Appear?
The good news is that savvy investors can continue to profit despite even a powerful bear market. In fact, some investors can become extremely wealthy during bear markets in a short period of time.
The most common way to profit when stocks are trending down is to short individual stocks and the indexes themselves via ETF’s and futures.
Using derivatives such as selling calls or buying puts is another time tested way to profit during bear markets. Be sure to understand options fully before you try this often lucrative trading tool.
Interestingly, bull market rallies during bear markets are often very sharp and severe. This means that investors can actually go long during bear markets and create strong profits. However, this is only recommended for nimble and experienced investors.
Buying solid stocks at steep discounts is another way long term investors can profit during bear markets. Sometimes, certain stocks, are simply too cheap to pass up. This is one way professional traders earn outsized gains.
Always remember that stocks often drop faster than they climb higher therefore the judicious use of stops is critical during bear market periods.
The Key Takeaway:
We firmly believe that the current market correction will not turn into a bear market. This is based on several fundamental facts and this time, it really is different.
However, should a bear market take place, don’t worry! There will be plenty of opportunities to profit on both the long and short side during bear markets.
Just remember to judiciously use stops! Moves in both direction can be account crushing during beat markets.