Risk Management In Bear Markets

Bear markets are full of volatile fluctuations.  That means there will be both significant run-ups and drawdowns.  This year, the S&P 500 has seen a +11% run-up in 11 days back in March, as well as a recent -12% drop in 11 days in June.  Technology stocks have been even more volatile, experiencing a +15% run-up and -14% decline in those same two timeframes.  As the markets fluctuate, we look to overbought/oversold conditions.  When the market becomes oversold, a rally is more likely to occur, and when it is overbought, there is more likely to be a decline.  As a disclaimer, it is very difficult to predict the timing and extent of those rallies/declines.
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A few weeks ago, we discussed that the markets were 99% oversold, meaning a short-term rally was more likely to occur.  From its low point on June 16th, the S&P 500 has run-up +6% through Friday.  Looking at overbought/oversold conditions (using AIQ Trading Expert Pro’s proprietary expert rating), the market is now 50% oversold.  In other words, there is an equal probability of a rally as there is a decline.

The recent rally in the markets has been led by the same sector that has led the market’s decline this year: technology.  The Information Technology, Communications, and Consumer Discretionary (which holds Amazon and Tesla) sectors have had the largest impact on the market’s fluctuations.  Recently, the Nasdaq index (which contains the largest technology-related stocks), has led the markets higher.  Looking at the index, each one of its rallies throughout the bear market decline has been done on lower volume.  Volume is a measure of conviction.  Lower volume on rallies indicates that there is less confidence in the rally. Aside from that, the Nasdaq appears to be at short-term resistance.

Source: Optuma Technical Analysis Software, using ETF: QQQ daily data

There are two things we know for sure:

1. Markets will fluctuate and you cannot control the market’s fluctuations
2. The Markets will eventually put in a new high

Given the two statements above, effective portfolio management is about risk management.  No one can control the market’s fluctuations.  That being said, you can control your portfolio’s fluctuations.  We also know that the market will eventually get to a new high.  We do not know when that will occur, but right now, it does not have the characteristics in place of occurring in the short-term.  We expect that markets will continue to fluctuate, and we must manage the fluctuations of our portfolio, so that the portfolio does not become a reflection of the markets.

In bear markets, there will be both substantial rallies and declines.  To manage this environment, it is important to limit the portfolio’s declines, so that with each subsequent rally, your portfolio compounds off of a larger base.  Remember, a -10% loss only requires +11% to breakeven, but a -30% loss requires +43% to breakeven.  After a -50% drop, you would need to get +100% to breakeven.  Limiting fluctuations is crucial to compounding your portfolio’s value.

We want to put our portfolio in a good position (limit declines) so that when the market’s volatility begins to decline, and characteristics turn more bullish, we are in a position to adapt our portfolio and have success.  The goal is to take a negative (volatility) and turn it into a positive (compounding).

_Every effort was used to provide accurate data and mathematical calculations to provide, what we believe to be, accurate results. Canterbury Investment Management, LLC, and its principal owners, make no guarantee of completeness or accuracy of data or calculations as well as conclusions of any statistical data or information contained in the simulation illustrated on this page. Past results or performance is in no way a guarantee of future results.   _