How To Spot A Bear Market Bottom, Part 1: Bull Market Top

I decided I'll make a series of posts on how to spot a bear market bottom. When bull markets top a trader has only two choices. He can try to short indices or individual stocks or sit on cash and wait for a bottom. A third option, riding a bear market all the way down is not acceptable and should not be exercised. In any case, spotting a bear market bottom is an opportunity that must not be missed. Markets are made to trick most of people. And most people won't catch an exact bottom. The ones who do, however, will make fortunes in the first and usually most powerful phase of a new bull market.

In this part we shall look at the first stage of a bear market which is a bull market top. The last two major bull market tops occured in 2000 and 2007. Both annotated charts are shown below.


Now, there are a couple of things to notice here. First and most important: a market top is a process, not a one-time event. Major tops take months to develop. 20% corrections are normal occurences and they don't necesserily mean that a new bear market has started. However, deeper corrections might suggest that market has already topped, as happened in Nasdaq 2000 top, which was the special case of a climax top. So shorting too early, anticipating a bear market, might be very bad for your portfolio.

The second thing to notice is that bull market usually tops when, after 15-20% correction, it cannot rally into new highs and keep the breakout. 2007 top is a classic example of this as market made a double top right above the breakout point and then collapsed.

Bear market is confirmed when the pattern of lower lows-lower highs starts to emerge. As long as uptrend line is valid, we cannot be sure that this is really a start of a bear market and not just an intermediate correction.

Now, let's see how this applies to the current market conditions. First, the length of topping process. Both 2000 and 2007 top took almost exactly five months to develop. History often repeats itself and so it did this time. How long did 2011 top take? Exactly five months.

The topping pattern was a classic head-and-shoulders. After marginal breakout to new highs in late April 2011, market soon dropped for another correction, which tested prior lows. After that a fakeout rally formed a right shoulder before neckline finally gave way and a pattern of lower highs-lower lows confirmed the start of a new bear market.

As we shall see in following parts, bear markets don't bottom that easy. It usually takes several fake rallies, which fool majority of traders, before market, when everybody throw in the towel, finally bottoms, leaving most traders behind. The main point of this post is to show some evidence why I think this bear market is far from bottoming. We have only witnessed the first stage after a top, which should be followed by at least two nasty drops. More on bear market stages is following.

Possible Neutral Signal

Today all major indices gapped down rigth below August lows and rallied violently since then. It looks like at least short term reversal is due. If strength holds into the close a neutral signal will be generated. Since I don't believe this is the final bottom before a longer rally, I will be looking for another shorting opportunity at MA50. However, we must stay flexible in case rally turns out to be strong. I also closed my SDS (2x inverse SPY ETF) long postition today an hour after open with a 15% profit.

When Will This Bear Market End?

Just want to share a couble of charts with you today about my long term view for the stock market.

After 20% drop stocks have been unable to rally. After a 10% weak rebound rally June lows are now jeopardized. I must say this is typical bear market action. In charts below you can see phases of last two major bear markets, the 2007-2009 and 2000-2003. The first thing to notice is that bear markets tend to have at least three, but usually 4 and sometimes even 5 downside moves. Most of these plunges fall into the 15-30% category. Usually the third or fourth drop is the most destructive, when market may loose 40% or more in a matter of weeks. Fortunatelly such crashes usually mark the start of new accumulation and late stages of bear market.


The next thing to point out is that bear markets tend to last from a year to 2.5 years, depending of the number of bear market cycles and strength of the previous bull market rally. The 2000-2002 bear, following incredible 5 year, 250% bull market rally, lasted about 2.5 years and lost 50%. The 2007-2009 bear market, following 5 year, 100% bull, lasted a year and a half, loosing around 60%.

The 2009-2011 bull market was rather short. In little more than 2 years S&P got 100%. Bear markets usually loose about 50% and so should this one. A more important question is how long will it last? My best guess is that it should be one of shorter duration, presumably between a year and year and a half. Why? Well, first of all, previous bull-bear market cycle was unusually long, spanning more than 6 years. I guess this one should be shorter to "catch up" the usual 3-5 years trough-to-trough rule.

Second, all that's been happening for the last 10 years is a consequence of a secular bull market that topped in 2000. The secular bear is ready to bottom. Quick bulls should also end quickly. After only two years of rising prices, this cyclical bear should bottom pretty soon. And if the economic timing at the bottom is right, we should be witnessing the start of new secular bull market starting a couple of years from now.