Last week in The Seed Sower we investigated the primary silver lining of bear markets. They make stocks cheaper thus providing a more nutrient-rich environment for growing our money. The challenge and the topic which we will address today is knowing when to go about planting your hard-earned cash for future harvesting.
Here’s the principal problem:
If you buy too early you risk big losses if the bear market turns from bad to worse. If you buy too late you miss what might have been the best, or at least quickest, part of the inevitable recovery.
Unfortunately, the market gods don’t exactly ring a bell at the end of a crash. Sure, there are common signs of a market bottom (think double bottoms, inverse head & shoulders, slowing momentum, etc.). But the end of every bear market plays out uniquely. This makes it challenging to identify which low is the low until well after the fact. The risks are encapsulated nicely in the quote above.
You either buy quickly during what could be the bottoming process and run the risk of being too early. Or you wait for definitive signs that a new uptrend or bull market has emerged, and then you pounce. Though, by then stock prices may have already risen 15% to 25% off the lows.
I believe the current episode proves our point perfectly. Consider the behavior of the Russell 2000 Index. At the Dec 24th pivot low IWM had fallen 27.4% from its peak. It was a large enough drop to qualify as an official bear market and then some. So, time to sow seeds, right?
The worry of plowing in at that point is that the 27% drop is only the middle innings of something more sinister. If we end up falling 40% to 50%, you will regret having sowed all your seeds too early. Alternatively, if you’re the type to wait for signs of a bottom you had zero reasons to buy at the end of last year. IWM was increasing in downside momentum and lacked any of the classic bottoming signs.
And yet, guess how much we’ve bounced since then? 12%! And if you’re waiting until we break above the 50-day moving average before declaring the bear dead, the market will already be up some 15%.
If you bought at the end of last month, then you’re hoping this rebound is the real deal and will lay the foundation for the next bull move. If you missed it, then you’re praying this double-digit jump is a ruse and we eventually roll over.
My preferred method for seed sowing is to do so incrementally. If I’m looking to invest $50K during the downturn, I might split my cash hoard into four separate piles of $12,500 apiece. Then I’ll invest them at various price thresholds such as down 15%, down 25%, down 35%, down 45%. Such a gambit ensures that I am capitalizing on the sale, but not throwing everything in unless prices become stupid cheap.
It’s an exercise in regret minimization.
One More Thing…
Studying the history or totality of prior bear markets gives a sense of the range of potential outcomes. It also allows the savvy trader to put modern-day moves in proper context. One of my favorite slides shown in the Bear Market Survival Guide displays the magnitude and duration of every bear market in the Dow Jones Industrial Average post-1920.