Real-time lessons from America on the art of navigating bear markets

To be fair, intuitively it makes sense.

Usually there is some terrible news, like bank crisis, subprime mortgage crisis, war, inflation, covid etc. The market has declined due to negative news. The news seems to be getting worse. Logically, this means that the equity markets may continue to slide further.

If one follows the above intuition, why should they continue investing in equities?

Isn’t it wiser to withdraw your money from equity and come back once things start improving? By retracing to the lower levels of the market, you can make good profits while avoiding further downside. Well! This is how many investors try to time the market.

While this strategy appears logical, it is unfortunate that certain contrarian patterns (also known as probing) that occur during market downturns make it incredibly difficult to get back into the markets after selling.

Welcome to “5 Counter-Intuitive Patterns of a Bear Market”.

In every bear market (read as equity market decline > 20%), there are 5 counter-intuitive patterns that play out opposite to what you would usually expect to happen. These unpredictable patterns make it difficult to get back into the equity market if you have already exited.

1. Counter-intuitive Pattern 1: Equity market recovery usually occurs in the midst of bad news – far ahead of earnings/economic recovery.

2. Counter-intuitive Pattern 2: Market declines have many false upside rallies and true recoveries have many false downsides.

3. Counter-intuitive Pattern 3: Recovery is usually very rapid – the first few months occupy the majority of the rally.

4. Counter-intuitive Pattern 4: We become psychologically fixed at lower levels.

5. Counter-intuitive Pattern 5: Even the experts cannot predict the bottom of the market.

Now let us apply these 5 counter-intuitive patterns to the current US beer market

US equity markets fell from 03-Jan-2022 and entered a bear market (read as more than 20% decline). It was down over 25% as of 12-Oct-2022. It has posted some recovery and is currently down around 14%.

In a historically rare occurrence, Indian markets have not experienced similar declines and have remained largely flat.

While we have ample evidence of these 5 counter-intuitive patterns repeating from past bear markets, we currently have a unique opportunity to actually see how this plays out in real time (via the US markets). Without the pain that usually comes with it (as India is not affected).

Now let’s say you have taken money out of the US equity markets after a 20% fall and are looking to get back in again.

Here are the dilemmas you will actually go through, and it will give you a good feel for why it is so difficult to try and time your entry back into the equity market.

Counter-intuitive Pattern 1: Equity market recoveries usually happen in the midst of bad news

There is obviously a lot of bad news in the US markets at present.

1. High US inflation

2. Fed raising interest rates

3. Concerns of a banking crisis due to problems at US regional banks and Credit Suisse Bank

4. High probability of US recession

Now despite all the bad news, the US market is up 15% from its previous low of 12-Oct-2022.

But we also know that market recoveries have historically come in the midst of bad news.

This is because markets are forward looking and recovery usually occurs much earlier than the actual recovery in the economy/earnings/news. It is needed to change the market sentiment from “things are”In fact “bad” to “things are bad”. This change in sentiment is unfortunately only apparent in hindsight and very difficult to predict in real time.

Historically, equity market recovery has preceded the actual recovery by 6-12 months.

Dilemma 1: Is this a real improvement amid bad news? Should you enter now or wait for news/economy/earnings improvement? What if you enter now and the market falls again? What if you wait too long and the market corrects?

Counter-Intuitive Pattern 2: There have been many false upside rallies in market declines and many false downsides in true recoveries.

We have already seen 7 false recoveries in this bear market. Three of them were over 10%!. Now we are seeing 8th recovery.

Is this a real recovery or another false rally?

Counter-Intuitive Pattern 3: The recovery is usually very quick – the first few months occupy most of the rally.

Dilemma: Should you wait more to verify or sign back in now? What if the market suddenly goes up and you miss the recovery? When should you come back in that case? What if you enter now instead but the market falls again?

Counter-Intuitive Pattern 4: we become psychologically fixed at lower levels

US equity markets touched a low of 3,577 on 12-Oct-2022. It is now up 15% to 4,124.

Going through your gut, it seems to go back to those lower levels. The current levels look psychologically expensive because you had the opportunity to buy them at a much lower level.

Dilemma: Should you wait for the last floor? What if the market continues to go up?

Counter-Intuitive Pattern 5: No one can predict the market in short term

Doomsday experts and hopeful scary predictions are in the news again.

Dilemma: No expert has historically predicted a market bottom on a consistent basis. These experts are also mostly wrong. So, how do you know when to enter back?

Now you can see how difficult and stressful it is to get back out of the equity market in the middle of a bear market.

parting thoughts

Thanks to the 5 counterintuitive patterns of a bear market, what looks like an easy decision to ‘exit and enter later’ turns out to be an extremely difficult and confusing decision with no easy solution.

This is why most people who exit the markets end up staying out for too long (longer than expected), missing the recovery rally and messing up their portfolios, destroying all the hard work of many years.

So, the next time you get tempted to ‘exit now and enter back later’, you know what to do. Or rather what not to do!

Author: Arun Kumar, VP & Head of Research, FundsIndia