Thursday, May 28, 2009

Trading the bear

Today I want to talk a bit about what one is up against trading a bear market. Why is it so hard to trade a bear market you ask? Well there are multiple reasons.

For one, markets don’t go up the same way they go down. Rallies tend to top out over an extended period of time as the fundamentals eventually reassert and hope slowly fades from the market.

Bottoms tend to be violent affairs as the market runs out of sellers and shorts cover into extremely oversold conditions. So not only is it very hard to spot the top as it happens it’s also very easy to get caught short at a bottom and lose 5-10% in the blink of an eye.

Then we can also throw in the fact that governments hate bear markets. They tend to fight them with the media, money and manipulation. The MMM as opposed to the PPT :)

Of course in a bear market the media is always looking for signs of a bottom. They have a tendency to spin every data point as positive. Let’s face it, they are going to sell a lot more advertising if the market is going up. They have a vested interest in promoting the positive and down playing the negative. At a market top, positive media spin has the effect of extending the topping pattern. We often see false breakouts as bear market rallies top out. These will often catch traders off guard who are trying to trade technicals.

We see incredible amounts of money thrown at bear markets. During the last bear market from 2000-2002 the Fed devalued the dollar by over 20% in an attempt to halt the bear. That, however, is dwarfed by what the Fed is doing this time. When trillions of dollars get pumped into the system it tends to distort things a bit. Let’s face it - money has to go somewhere. Inevitably some of it ends up in the stock market.

Last is manipulation. Now I’m not talking about the plunge protection team. I have to laugh when I see investors blame the all powerful PPT anytime the market doesn’t fall when they want it to. Folks I can say without a doubt that the markets are too big for anyone to manipulate for anything other then the very short term and that includes the US government and the Fed. If the PPT really could control the market then one has to wonder how the S&P went from 1575 to 666 in only 18 months.

That’s not to say the Fed doesn’t pump in lots of liquidity and maybe even at critical times when the market is at an important inflection point. I suspect they do. However those are only going to be temporary stop gaps. The market will finish what it was going to do no matter what the Fed does.

I’m thinking more in terms of changing the rules in the middle of the game. Like banning short sales on financials. Or trying to control long term interest rates. Or cutting interest rates before the open into an options expiration. Or issuing a buy recommendation on a bellweather stock (AAPL) right as the market is about to break an important support level. One never knows what the powers that be will throw at the market next in a desperate attempt to halt the bear forces. This makes for a very volatile investing climate. One that can play havoc with investor expectations and trading strategies.

I’m also quite sure the government isn’t above massaging economic data to achieve their goals. Hell, they’ve been adjusting the CPI and PPI data for years and I’m pretty sure the true unemployment figure is higher than 8.9%

So one can try to trade the bear if they want, just realize you have a lot of obstacles in your path trying to make it as hard as possible.

Now you see why I prefer to just buy into a bull market. If you really want to trade a bear market wait till the commodities bull finally comes to an end. I guarantee the government will be on your side at that point! Of course you may have to wait another 5-10 years.