Lessons From Macro Man

Bears Have Rallies, Too

Thursday, October 30, 2008 at 8:53 AM Posted by Macro Man

“Bear markets are famously difficult to trade. Why is that? Perhaps it’s because most investors are natural buyers and owners of risk assets, so the secular market direction leaves them out of pocket and damaged psychologically. Thus when the faintest whiff of a trend reversal, however temporary, materializes, they are naturally inclined to jump all over it, generating out-sized short-term returns. This is why Macro Man asserted yesterday that 10% daily rallies don’t occur in bull markets.

Of course, when reality sets in once again and the underlying bear emerges from his hibernation, risk asset longs are left more out of pocket and more discouraged than before. Lather, rinse, repeat.

In any event, it seems that the dawning of the latest bear market rally is here. Perhaps it’s driven by month-end rebalancing considerations. Perhaps it’s driven by the forthcoming election of St. Barack. Or perhaps it’s just driven by bear fatigue. Yesterday’s late session swoon by US equities notwithstanding, it does seem like it’s here. (Of course, there’s also been news…but since when did that matter?)

Of the three explanations above, Macro Man favours the first and the third. The first speaks for itself and should pass within the next few trading days. The third represents a waning downside momentum as sellers of risk assets received a deteriorating marginal bang for their buck. Positive divergence (rising momentum with lower prices) has been observed…

So what do you do from here? Stick to your risk-asset shorts and wear the short-term pain, which might be very substantial indeed? Or go long risk for a rental and hope you can sell out to someone else before the music stops? For Macro Man, the answer is “neither.” Bear market rallies are like bad oysters; if you partake, you’ve gotta be pretty lucky not to end up being sick. He’ll pass, thanks, trim his bear market risk and concentrate on stuff with a more powerful, long-term macro theme (oh, and where he has his risk in limited-loss strategies.)”

Macro Man makes some excellent points here. I make no such attempt to forecast the market and its general trends; in the long run the market can only reflect the real output of the economy. Even so, I can’t help but wonder whether or not the market has already been discounted for future economic downtrends. I also wonder about changes in general sentiment, and when they will occur.

In a bear market, three common stages appear (Marks, 2008):

  • the first, when just a few prudent investors recognize that, despite the prevailing businesses, things won’t always be rosy
  • the second, when most investors recognize things are deteriorating, and
  • the third, when everyone is convinced things can only get worse (also called “the bottom”)

Marks goes on: “One of these days, though, we’ll reach the third stage, and the herd will give up on there being a solution. And unless the financial world really does end, we’re likely to encounter the investment opportunities of a lifetime.”

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~ by eboro on November 1, 2008.

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