Recession Watch: Trading in bear markets

Underlying market conditions require a trader’s approach to the market to change when conditions shift. First, market dynamics are always evolving and the cycles are always changing. The bull market of the late 1990s, with its very high volatility as increasingly frenetic tech stocks reached their peak in 2000, bears no resemblance to the post-tech stock crash bull market of 2002-2007 and its ever-tapering volatility.

The bull market that came in the wake of global financial crisis bore many resemblances to the prior bull market, and now that we are more than a decade removed from the last true bear market, many traders have never experienced sustained bear market conditions. That lack of experience is a a potential danger.

Since the volatile tech bubble back in 2000 and the short – and very deep – financial crisis era aside, conditions have encouraged passive exposure to risky assets as it became overwhelmingly evident in recent years that most mutual funds and even hedge funds are hard put to outperform index benchmarks. Trying to time the market has also been futile for many momentum traders, as most panics nearly always reverse in short order.

There were sustained exceptions, of course, as most of 2015 was bad for global markets – and downright awful for emerging markets weighed down by a strong USD. But 2018 was nearly a perfect storm, an historically bad year for returns across all asset classes as there was virtually nowhere to run and hide. And in December of 2018, it almost looked as though something broke, and we saw the worst December for the US equity market since the Great Depression of the 1930s. 

In early 2019, it appeared that the market’s animal spirits had been heavily revived by a sudden about-face from Jerome Powell's Federal Reserve - from hawkishness at the December 20 Federal Open Market Committee meeting to clear dovish signals in January of 2019. But a new bear market may almost certainly be upon us if a recession is on its way.

If that’s the case, what can traders do to prepare?

Things to keep in mind when trading in bear market conditions

If we are set for a sustained bear market in risk appetite, traders may want to keep the following in mind to maximize peace of mind and minimise risk while still look to reap trading gains in the oft-frenzied trading environments that are the signature of bear markets.  

Keep exposures appropriate to volatility – in both directions: In bear markets, recognise that trading ranges can expand to multiples of the average recent volatility. Appropriately-scaled positions will allow traders to stay in the market sufficiently long to be proven right or wrong. As well, the large trading ranges of volatile markets are driven by poor liquidity and the expansion in trading ranges is not only to the downside, but to the upside as well. So one can be bearish in the context of a bear market, but get squeezed out during these vicious upside rallies.

Does anyone much recall or discuss the steep, 27% rise in the US S&P 500 from late November 2008 to early January 2009? The following chart shows that the markets’ best trading days over the last 40+ years have come in association either with bear markets or during a steep correction.

Largest single-day S&P 500 rallies (1987-present, in percentage rise)

Rank 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Change 11.58% 10.79% 9.10% 7.08% 6.92% 6.47% 6.37% 6.32% 5.73% 5.42% 5.41% 5.33% 5.14% 5.12% 5.09% 5.01% 4.96% 4.93% 4.77% 4.76%

Date 10/13/2008 10/28/2008 10/21/1987 3/23/2009 11/13/2008 11/24/2008 3/10/2009 11/21/2008 7/24/2002 9/30/2008 7/29/2002 10/20/1987 12/16/2008 10/28/1997 9/8/1998 1/3/2001 12/26/2018 10/29/1987 10/20/2008 3/16/2000

Maintain optionality: During the quiet, or at least quieter, periods of bear markets, exposure through options (long volatility or long/short combinations like long put/call spreads) allowS traders to maintain a position and have a degree of distance to the risk of wild swings in markets. A long volatility position allows a trader to know the maximum risk and that at least a position can be maintained until the expiry date of the option.

Keep some funds in reserve for excessive pessimism: Traders should be careful not to fully commit an excessive percentage of capital to only one outcome – especially over a short time horizon. In the modern era, this has proven doubly necessary because of the rise of more forceful policy responses that can turn market sentiment so quickly. One longer-term strategy is to slowly raise allocations to risky assets like equities if declines accelerate in parabolic fashion; market turns inevitably happen when things can’t seem to get any worse.