• kennethkohwk

Finding the end of the bear market of 2022 (Surivivor Series Part 1)

I am on hiatus, I am not supposed to be posting until Dec 2022.


However, I felt compelled to because of recent events in the stock market.


When I was a beginner investor, I thought I was an intermediate investor after a couple months and reading alot of material about the financial markets. One of the things about the financial markets that mimics real life is how we really don't know what we don't know, and so we build monoliths, reasons, institutions, to create reasons for why certain things in the markets happen.


For example, I often heard, "bear markets are caused by recessions..." especially by professionals who are put in pedistals. Yet, some times there are certain things that contain obvious truth, but have little practical value. This sentence is one of them.


Why?


Because very often in history, bear markets and recessions are seldom in synch. There are times that a bear market can start months, even more than half a year before an official recession is annouced. On the other side of the tunnel, when a recession become obvious, the bear market is usually closer to being over when closer to the start! In rare cases, the bear market in the stock market can be practically over by the time a recession hits!


The insiduous and tricky nature of the stock market is that in order to do well, you have to be able to see things in advance before it hit mainstream news, and if you are reacting to mainstream news, you are likely too late, or in an disadvantaged position to take full advantage of it.


Below is a series of bear market and recession time lines in the last century.


You soon notice that:


Recessions and bear markets don't overlap very well at all.
  • Often, bear markets start before a recession is officially called.

  • Markets can recover months before a recession is officially over.

  • There were also four bear markets that did not overlap with recessions- 1946-1947, late 1961-62, 1966 and 1987.

  • If we are close to an “official recession”, history implies we are likely at the last one-third of the bear market, or at least closer to the end than to the beginning.

Source: Schwab.

This why most investors are told wisely that they should not try to time the market and just dollar-cost average into the markets. The reason is because more often that not, the overly negative news (which are very TRUE- that's why it's insiduous) often causes the average investor to sell too late, and the overly positive news (which is also true! great employment! GDP growth! Analysts are bullish on their stock recommendations) often causes FOMO and they also buy more stock at the wrong time.


The start of a strong reversal can start without any "reason" or "fundamental reasons" in the news cycle.

... although to sustain the rally, the market needs those "reasons" that make sense in the news cycles. News that makes the average investor happy... great earnings, loose monetary policies, no turmoil in the world, etc.


The last week of trading so obvious was revealing this "man behind the curtain" pulling some wool over your eyes for those who were paying attention.


What was the main narrative that seemed as religious dogma in the last couple weeks to explain the falling stock market?


It goes something like this:

  • Inflation is getting out of hand and there is no hard evidence it is abating.

  • The FED kept reinforcing a hawkish tone, that they will continue to raise rates sharply until inflation is under control. (Although I argue that this inflation is a supply side inflation, and so I wonder the wisdom of causing demand destuction to tame inflation.)

  • Hence, the FED is going to raise rates until we hit recession. The outcome is inevitable.

  • The trouble in the debt markets is the first salvo.

This was the narrative all throughout the selloff in Aug and Sep 2022.

Of course, its a "coincidence" that the sell off started mid Aug, which happens to be exactly on the major resistence of the 200DMA.

Most people will say it makes a lot of sense, and it actually does... until it doesn't. But, smart money isn't going to tell you when it doesn't, that's the rub.


13 Oct 2022 was supposed to be D-day.


For those who are conventional technical analysis traders, you had a negative breakdown on key support levels. We plunged below the 52-week lows set in June and the beginning of October. Techical analysis 101 tells you that this is a breakdown of the key pattern (a form of H&S) and thus a plunge to 3300 and below was supposed to occur.


Lots of people were expecting this. A large part of me thought so too, because all the conventional news was pointing towards this!


Yield curves were inverted. The FED was hawkish. News all over world of high inflation for rent and food was all over YouTube. Investments banks were prognosticating more economic damage.


A sustained breakdown was supposed to happen.


I even thought to go short the night before.


But I couldn't sleep, and decided to close all the shorts.


Why?


Because of the analysis of the last three posts that I did the week prior.


The thing that was holding me back was from my experience as a market timer and statistically looking at things that don't make the headlines. I knew that the markets were too overly bearish, and lots of correlations between sentiment and economic data was telling me that we are already at an extreme in terms of how bearish it can be. Experience told me that all it takes is a small spark to create a whole lot of short covering and maybe even start an intermediate rally. The numbers were ripe for an intermediate rally.


But I was lacking a catalyst. I couldn't think of any news that might reverse the market.

The FED seemed resolute to tighten. Inflation seems unabated. People are suffering in the world. Companies were being downgraded in earnings.


This was extremely difficult. But I chose to adopt a quantitative approach. I determined that this is not a good time to go short, even when basic price pattern technicals and the mainstream narrative was saturated into bearishness.


I closed my shorts. I second guessed myself the entire way... i really didn't want to.


The next day, the pre-market was very negative. The Dow was down -500 points before the day started.


I told my wife I hate myself for closing my shorts.


I knew there wasn't any obvious catalyst to save the market out there... so why didn't I go short?


Then the amazing thing happened.


The markets did a historical reversal and not only closed the -500 points of the Dow, but even closed more than 1000 points higher.


Here's the rub.


It happened on NO NEWS at all.


I scoured mainstream news and financial websites. No one had an explanation to why there was a sudden burst of strength. Not a single one.


I was almost comatose.


The statistics of the indicators I was working on turned out to be correct, that we were ripe for some kind of strength, even when there wasn't any "fundamental" reason for it!


I went from being angry that I closed my shorts to "I can't believe I actually closed my shorts" because I had to fight so much inside of me to close my shorts the night before. We were supposed to have that H&S breakdown! The classic bear market indicators were blatent.


I guess this is why I do what I do... I feel a responsibility to see all sorts of correlations, to determine when bottoms or tops (mainly intermediate and absolute, I don't really care for short term bottoms because I'm not a day trader now.) Because, I know the game of the market is designed (by accident) to sucker the average investor.


If you read some basic technical or fundamental analysis textbooks, or read some macro calls from some big broker, you were going to think further downside is the no brainer... which is what initially happened. There is nothing that would make you think a powerful 1000 point move was going to start on NO NEWS whatsoever.


Now it gets more interesting.


I don't it is possible to have a full intermediate rally without some kind of narrative that can create at least some hopium. It's not logical to expect more 1000 point up moves without the media trying to find reasons for it that makes sense.


What happened yesterday?


Just as the market was slowly selling off from the initial surges of a couple days back, the FED suddenly announced that they are considering lowering their rate of interest rate tightening in their dicussions for their next meeting... straight away causing a drop in interest rate yields and a rise in the stock market!


https://www.nasdaq.com/articles/treasuries-u.s.-yields-slide-from-multi-year-highs-on-hopes-of-fed-pivot


This means that now we have a potential catalyst to cause some hopium that might continue the intial surges in the stockmarket into an intermediate rally that already has a bullish seasonality going into Nov and Dec 2022!


Seasonal Patterns are supportive of this too.

Based on seasonal patterns on all midterm years, the S&P500 is always weak from Aug into the Oct, and then a end of year rally starts from Nov to Dec.


Could we be having this?

A week before this unlikely strong start of a potential rally, I was warning the ground was ripe for that to happen.

According to the stats I listed in my last couple blog posts, I showed that the powder peg is already set and all it needs is a spark to get going.


From "An intermediate bottom in the S&P500 now?" dated Oct 4, 2022.

https://www.quantzombie.com/single-post/an-intermediate-bottom-in-the-s-p500-now

We already warned that an intermediate bottom might already be brewing.


From "The Rubber Band is stretched" dated Oct 13, 2022.

https://www.quantzombie.com/single-post/the-rubber-band-is-stretched

  • The Smart Money / Dumb Money is at intermediate snapback extremes.

  • The SPX Put/Call ratio is the highest since 2014. Traders are really bearish.

  • Divergences were occurring in the market internals even as the S&P500 was drifting to new lows.

From "The Critical Point for the S&P500" dated Oct 11, 2022.

https://www.quantzombie.com/single-post/critical-point-for-the-s-p500

The market is on super strong quantitatively price support.


We mentioned here that although it's quite possible to see new lows before seeing new highs in the market (we continue into a bear market in 2023), an intermediate bounce is very probable. I even drew out what I think could happen even when the price lows were already taken out! I ignored my technical analysis CMT level 1 and 2, and looked at my statistical models to draw this possibility.


Note that the price pattern I drew is NOT time-accurate or price accurate. The point is that it's highly likely an intermediate rally could happen before a break down into new lows. The rally will likely find support in Nov and Dec.


Note that I am also not guarenteeing that we will definitely hit new lows by early 2023.

We will have to see how the market shapes up then.


But as of now, based on the classic bear market indicators, a further bear market is likely unless inflation abates quicker than expected, supply chains repaired quicker, and the FED eases off on rate hikes. This could happen, but it's a possibility, not a probability.


Now that we've gotten my introduction out the way, I want to discuss the point of this blog post.


The point is that many times, the "news" and "fundamental" news will not get to you in time to catch big reversals in the stock market. Hence, it becomes imparitive (if you want to outperform the market), to use history and statistics to give you ideas you can work with to determine how to position yourself.


Since we know that bear markets and recessions don't line up perfectly at all, if you wait for companies to report improving earnings, if you wait for GDP or employment to improve, if you wait for a sustained reduction in inflation, you might be very late to catch the bottom.


Estimating where the potential absolute bottoms in the bear markets could be based on historical average downsides.

Here's a simply idea of how to place ourselves in terms of timing and downside in the present bear market.


•Average bear market downside with no recession: -29%.

•Average bear market downside with recession: -42%.

•Average all bear markets: -32%.

RIght now, we haven't had an official annoucement of a recession, but it feels like we are in one.


In terms of average downside and history, the average possible outcome for us, if history repeats, is a downside from all-time highs for between -29% (for no recession) and 42% (with a proper recession).


Taking these downside %s and applying them to the S&P500 today, here are the possible downside targets based on this historical downside average approach.

Since the FED is tightening rates at the highest speed in near history. It would be odd if the price didn’t eventually go into the 2900-3550 zone, which is the average bear market downside from the mildest case of no recession to a recession… unless the FED pivots soon.


I think a case can be had that an "official" recession might be annouced soon.


We seem to be almost at a point where a recession is called.

This fact that we are close to a point where a recession is called is actually very useful because it's marker that can be used to estiimate where we are in the bear market!


Leading Economic Index (LEI):

The yellow dashed line indicated the average percent drop at which the index has been (-2.2%) when recession have started. We are almost there.

The LEI seem trending downwards, so we might get there soon.

Historically, if we are close to an "official" recession, it implies that we are likely at the last one-third of the bear market. Or, at least closer to the end than to the beginning, if history rhymes.

This "end" is based on time, not downside.


What about downside?


Tactics and Summary

  • Best case scenario: avoid a recession, FED pivots quickly. Average downside: -29% vs -27% (hit on Oct 14, 2022). The bottom could already been in!

  • Recession scenario: average recession. FED continues tightening into recession. Average downside: -42% VS -20% (as of 21 Oct 2022). Price-wise, it seems like we are halfway.

  • The probabilities are likely we are somewhere in between.

  • The idea of a going into recession in the next 12 months is no longer “smart money” news.

  • Probable an official recession will be called soon.

  • However, bear markets are usually at their tail end (last 1/3) by the time an official recession is called.

  • The historical average bear market drawdown is -32% (vs -20% as of 21 Oct 2022). If so, especially when circumstantial evidence points to an official recession being called soon, implies we could be in the last 1/3 of the bear market.

  • We are already approaching price levels that historically in the zone that bear markets could end depending on how mild or severe the recession.

  • When the absolute bottom comes, there will be significant things to look out for to give you a hint it's around the corner ... divergences, extreme correlations, propritary models, absolutely irresistable valuations in certain companies, smart money plays. These are the things I like to analyze like a detective.

  • It is important to detect when the intermediate rallies are and play them with good entry because one of them will be the ultimate bottom.

  • When positioned properly, you can even make money in a bear market. And, with good risk management, likely won’t lose much if you must cut loss.

  • If I do post, I will post during moments when key factors line up together to give a high probability of intermediate bottoms.

  • In my next couple blog posts will be a continuation of this post. I broke it up because I had alot to say.

  • I also share a proprietary indicator that recently I optimized by myself, that is a way to detect risk on vs risk off regimes to play those intermediate rallies. When risk on, you have “permission” to try the long side. When risk off, stay out or go short. This means that in addition to the getting to those oversold areas in the market that might be potential major bottom points, this indicator will add even more reward to risk by getting you by highlighting the short term bullish zones.

My friends, I will end this post now.


Stay safe everyone, I hope this post finds you well. May the rest of 2022, and 2023 be of great cheer to you.


Let your heart not be troubled.



Disclaimer: This site has been designed for informational and educational purposes only and does not constitute an offer to sell nor a solicitation of an offer to buy any security which may be referenced upon the site. Please consult your own financial adviser to determine what trade is appropriate for you. See our full disclaimer here.


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