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“The investor’s chief problem—and his worst enemy—is likely to be himself. In the end, how your investments behave is much less important than how you behave.” -Benjamin Graham

  • Stocks are retesting June lows.
  • Buying in bear markets requires different rules than in bull markets.
  • A cautious approach can help you avoid big mistakes.

Stocks tumbled last week amid growing concern that taming inflation would require increasingly hawkish Fed policy, pushing the economy into a deeper recession. As of this morning, the S&P 500 ETF  (SPY)  is down 6.5% in September, bringing its year-to-date return to -21.7%. It's now down 13% since I wrote “Is It A Good Time To Sell Some Stocks?” on August 17th.

That’s a heck of a haircut in a little more than one month, but stocks don’t fall (or climb) in a straight line, and there’s growing reason to suspect stocks could be setting up for another bear market bounce soon.

Previously, I discussed why indicators have Top Stocks’ Helene Meisler expecting stocks to be oversold this week. Her indicators are likely flashing even brighter today, given the S&P 500 tested its June lows on Friday and again today, creating substantial ‘fear’ among investors that we could break down.

A potential bear market bounce could make it a good time to pick up stocks on sale. However, bear market rallies aren’t to be trusted. They vary in size and duration, and until the bear is slain, they stall at resistance because investors trapped in positions above are eager to sell. In short, the buy dips and expect new highs strategy that works in bull markets is of little use in bear markets.

In “How to Manage Risk While Building Long-Term Positions in a Bear Market,” Real Money’s James DePorre highlights seven rules for buying during bear markets that can help protect your capital. 

Here’s DePorre’s playbook for buying in a bear market, followed by my comments.

1. Build a Shopping List

The first step is to identify those stocks that you feel will be leaders when market conditions shift. It is important to recognize that in a bear market, price movement tends to be correlated and index-driven. Many great stocks are sold without regard of their fundamental values because they are part of an index or ETF that is being sold.

We will discuss stock-picking in much greater depth in future articles, but the key is to find some new ideas and not just hope that the stocks that worked in the past might work again. There will be new leaders in emerging bull markets, and those are the names where you want to invest your capital.”

Yesterday’s big winners aren’t usually tomorrow’s big winners, so keeping a running watch list of stocks worth targeting is useful. Of course, everybody’s investment style is different, but historically, big winners have common characteristics. For example, growth investors ought to focus on finding stocks boasting healthy double-digit year-over-year revenue and earnings growth rates. Value investors can seek out companies trading at the low end of their historical price-to-earnings ratios (except for commodity cyclical, where the opposite pays off.) And technicians can concentrate on stocks exiting bases, making higher lows, and outperforming the index. I discuss these concepts more in How to Find Winning Stocks.

2. Stalk Your Targets

Once you have a shopping list, don't just plunge in. It might make sense to take a small tracking position that will keep you attentive, but you want to learn the personality of the stock and how it a reaction to the overall market environment. You should gain a sense of whether it has a fundamental value that is being overlooked due to market conditions.”

The temptation is to go “all-in” with a position to maximize your potential return. However, this is often less driven by conviction and more by investor bias (you can read more about bias in 8 Investing Biases That Hurt Investors). 

Instead, consider taking a starter position if you think the time is right, like Co-Portfolio Managers Bob Lang and Chris Versace do with the Action Alerts PLUS portfolio. 

Rather than establishing a full position at once, they break it down into smaller chunks, then use market volatility to buy more at key levels. For example, if your typical portfolio weighting is 3%, consider buying 1% upfront, then buy more when opportunities present themself, such as at technical support or if it breaks above technical resistance.

3. Watch the Chart

The biggest mistake that most people make in a bear market is being into the teeth of a decline. The emotional reaction is that the lower a stock goes then, the better value it must be. That may work with consumer goods, but it is illogical thinking when it comes to stocks. The goal with stocks is to buy them when they have the best chance of sustained upside. You do not want to tie your money up in a stock that is a great value but then never goes up. The market has to recognize the greatness of a stock for it to move, and the best clue that that is occurring is when there is relative strength.”

This goes a little against conventional buy-low wisdom, but DePorre’s point is that nobody rings a bell at a bottom, and individual stocks can fall much further than you suspect. 

Remember, just because a stock has fallen 80% to $20 from $100 doesn’t mean it can’t lose another 50% to $10. So rather than trying to catch a falling knife in hope (a four-letter word, by the way) of nailing the absolute low, wait to see the stock prove itself by turning higher or outperforming the index.

4. Use Support Levels 

One of the benefits of buying a stock after it has shown some strength is that the prior lows become very clear support levels. If those support levels fail, then you may need to reposition and question your view of whether this is the right time to be aggressive at expanding a position.”

One of technical analysis’s big advantages is that charts show where aggregate investors believe there’s value (support) and risk (resistance). This Credit Suisse primer is excellent if you want to learn about technical analysis. If you want to learn tips on applying technical analysis, I discuss it in How To Use Charts To Improve Performance.

5. Average Up and Not Down

The biggest losses for most investors occur when they continue to add to a position as it keeps on dropping. The position becomes uncomfortably large, and then they panic sell when it refuses to bounce. It may have just been a bad stock pick. Positive price action can help you confirm that you are on the right track. If the market is recognizing that a stock is a good one, then that is the time to add to your position. A good stock will continue much higher, and your risk is reduced when you are buying strength rather than weakness.”

Similar to rule number three, this takes a little getting used to because we’re told repeatedly not to “overpay” for things. It may help to remember, however, that while stocks can fall to zero, they can rise to infinity. So, there’s far less risk of overpaying for an outstanding stock than you might think. Remember, in a bear market, risk control is critical. If you keep buying a falling stock, it can quickly grow to an outsize position, taking a bigger-than-expected toll on your account balance; especially if you’re on margin (aside: Avoid margin, particularly in bear markets!).

6. Trade Around a Core 

One way to reduce risk as you are building a long-term position is to trade around a core position. Use volatility to buy and sell partial positions but keep a core position as long as your long-term view of the stock remains the same. The shorter-term trading allows for greater flexibility, and if done right, it can reduce your cost basis substantially.”

Every buy or sell decision should be based upon a thesis, regardless of whether it's fundamental or technical. If the thesis breaks, then you should exit the position.

However, if your thesis remains intact, consider playing the edges to reduce your drawdown. In practice, consider buying at downtrend support and selling at upside resistance. However, be careful. You want to actively trade a much smaller stake than your core (ex. 1% of a 3% position). If you don’t, you risk poor timing on your active trading will influence how you behave with your core position. 

The Smart Play

Surviving a bear market is easier when you have rules and the right mindset. There will be bargains, and eventually, a bull market will emerge. However, the key is avoiding mistakes that hamstring your profits when bulls are back in charge.

Remember, the S&P 500 has marched to new highs following every past bear market, but that’s because its holdings are diversified and continuously changing. As a result, dollar-cost averaging into it is quite different than buying individual stocks. With individual stocks, you need to be even more cautious. For this reason, proactively plan trades and trade plans. Too often, investors approach buying during bear markets with a fly-by-the-seat-of-pants mentality. That’s a surefire way to wind up in a losing position. Instead, embrace a rules-driven approach to ensure your behavior doesn’t undermine your long-term goals.

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