Bear market behavior

If you are a diligent investor, then you might spend time everyday reading about the economy in Wallstreet, listening to Jim Cramer, evaluating your choices in Morningstar and then doing your homework about each pick that you are going to make. But despite all this preparation, you might still be surprised on the day when the stock market tanks! I mean big correction. Or if you are a seasoned veteran, you might not be surprised about the correction that just happened, instead you might be feeling that this bull market had run a long course before it ran out of steam.

No matter what your individual opinions are, the will of the free market is going to reign in, whether you like it or not. All an individual can do is to respect the rules of the market and play by the merits of it. Understanding the market is the first step to play "the market" game and particularly, the bear market is of greater importance because that is where most people get hurt.

If you pay particular attention to the bear markets, you see that there can be many reasons that really triggered the downfall. But regardless of what triggered the sell-off, the chart of a primary bear market exhibits a certain pattern most of the times. A primary downturn usually exhibits 3 phases.

The first phase starts in the later part of the Bull market. This is when smart investors who are well tuned in with the pulse of the economy start their unloading of stocks into the market. These are the people who can see the trouble brewing in the market and can foresee the trouble becoming a potential downtrend. The market might still be making record highs, and average individuals are still talking about their recent successes and planning their next stock purchase. But a potential clue at this point is that the volume might be diminishing on the rallies.

The second phase is when the sellers panic and they want to get rid off their stocks urgently. There will be hardly any buyers at this point, driving the prices lower. There will be a huge selloff with a big volume posted on the chart. Usually on these days I see that CNBC anchors like Maria Bartiromo putting on a sad face while reporting the bad news. I guess they are trying to be compassionate for the traders who would be loosing their money then. After this selloff there might be a small secondary recovery or sometimes a sideways movement.

In the third phase, there will be more distressed selling. Many traders cannot go without cash for long, and they need to take some money out of the market. There will be some more selling and prices go lower further. Lower quality stocks will loose most value, and good quality stocks can take a little hit too. This will be a good time for buying into the market and stocking up on your favorit stocks. This phase will continue as long as the bad news will last.

Armed with this bear behavior pattern, let us see where we stand today. In the chart below, we might still be in the phase 2 (as of 7/27/2007). I am not suggesting that we are in a Recession yet, but we might be just in a correction.

-Nidhi