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How to Invest in Expectation of a Bear

Written By Briton Ryle

Posted October 27, 2014

Investors beware, the current bull run is almost out of power, say a growing number of economists and market commentators. And they have some pretty good reasoning that leads them to that conclusion: the market always repeats itself.

What makes the bearish prediction even more warranted this time around is that we have already seen this repetition twice in the last 14 years since the start of this century, each of which saw a raging double-bull turn into a ravenous 50%-corrective bear.

Now they are saying we are due for a third iteration of this market pattern. When are they expecting this bear to attack? During the presidential election of 2016.

But proponents of the theory have more than just historical patterns to back them up. They also have future expectations of changes to monetary policy reinforcing their belief that the current double-bull will end in less than two years.

Should we believe them? Is there anything we should be doing differently even if they are right? The answers to these two questions may seem contradictory: yes, we should believe them; and no, we mustn’t change a thing if we are already investing the way we ought to.

The Bull-Bull-Bear Cycle

Here’s the pattern that is expected to repeat for a third time: “Two bulls back-to-back, with no bear market in between,” columnist Paul Farrell introduces.

Referencing the work of publisher Bill O’Neil, Farrell explains that “the bull cycle runs for an average of 3.75 years. Then falls into a bear an average of nine months. The pattern skipped 2013, creating today’s Double Bull.”

“But market giants are warning, bye-bye bull,” Farrell warns. “Jeremy Grantham, founder of the $117 billion GMO money-management firm, predicts another megatrillion dollar crash, repeating the bears of 2000 and again in 2008. Wall Street lost roughly $10 trillion each time. Graham says the next bear will hit around election time 2016. The third $10 trillion stock crash early in this new 21st century.”

Indeed, there have been cycles of double-bulls turning into devastating bears, and each one ended on a presidential election year, as noted in the graph below of the S&P 500 index.



First, we had the bull run from 1993 to 2000 which was followed by a 48% correction from 2000 to 2003. The turning year? The election of President George W. Bush. They call this a double-bull or back-to-back bulls because there was no market upheaval during the 1996 elections (although if you look closely you can see a little bit of a dip in the middle of 1996).

Second, we had another back-to-back bull run which turned into the 55% correction of 2008 — another presidential election year. Since the presidential year of 2004 saw no market upheaval, this run also qualifies as a double-bull (although here again we see a little bit of a dip in the middle of 2004).

This gives us one pattern repeated two times already: a double-bull spanning two presidential cycles, with a little harmless dip in the middle during the first presidential election, and a devastating collapse at the end during the second presidential election.

Where are we now? We seem to be in the latter stages of yet a third repetition of the cycle, having enjoyed a double-bull run since 2009, skipping the presidential election of 2012 with nothing more than a 6-7% scratch. If the pattern continues, the current double-bull is due to expire in 2016.

On the non-technical side, however, there could be a simpler explanation for the two bear markets than a hard-fast rule of bull-bull-bear every two presidential cycles. The election of President George W. Bush in 2000 saw the transition from a Democratic administration to a Republican one, while the election of President Barack Obama saw the transition from a Republican administration to a Democratic one. Changes like these are in themselves game changers in the marketplace, since investors expect certain industries to behave differently under different administrations.

Another argument that also dispels the bull-bull-bear cycle across two completed presidential cycles is found in the charts themselves. Looking at the graph again we notice that the send double-bull did not end in the 2008 election year, but rather in 2007, the year before. We also notice that the reason the 2012 election year was “skipped” was because we had a hefty 18% correction the year before in 2011, which was not an election year. We also saw a 25% correction in 1998, again not an election year. These details throw the double-bull-in-double-presidencies theory a little out of alignment.

Even so, we can’t deny that the two major corrections of 48% and 55% during election years are far more prominent than the 18% and 25% pullbacks of other years.

So is there something to this bull-bull-bear pattern after all? And will we see another bear in 2016? We likely will see another bear then, but not for the reason of any pattern. This one will have more to do with changes by the Federal Reserve than by changes in the White House.

Why 2016 May Be Pivotal After All

It does seem quite likely that the bullish momentum we have been enjoying in equities since the economic recovery began in 2009 might come to a pause in 2016. But it won’t be because of a new President in the White House, rather because of the Federal Reserve’s tightening of monetary policy when it finally begins raising interest rates after more than five years of hovering slightly above zero percent (by then it will have been more than seven years).

At the end of the Federal Reserve’s meetings scheduled for tomorrow and Wednesday, we should receive word that the final piece of the QE3 pie of monthly bond and mortgage-backed securities purchases will be gobbled up this month, ending QE entirely. The next step after this will be for the FOMC to begin raising interest rates as the economy continues to improve.

However, with housing sales and construction slowing down, and global partners in Europe and Asia showing signs of stagnating, it is quite likely the U.S. Fed will put off the raising of interest rates for a “considerable time”, wording which is taken right out of the last several FOMC statements. In this week’s press release investors everywhere will once again be looking for these two critical words for some kind of guidance.

If the global recovery takes longer than expected, then the raising of rates in America will too, perhaps pushing the first rate hike into Q2 or Q3 of 2016, right around election time. If so, then definitely the markets will be set for a tumble, as the raising of rates makes money more expensive to borrow, adding to company operating costs, cutting into profits, and triggering stock price corrections down to lower levels of slower corporate growth.

So the predictors of doom in 2016 may be right after all, though not necessarily because of a set pattern, but more out of coincidence that it just happens to be the time when the Fed begins tightening.

How Investors Should Prepare

All right, so regardless of the reasons and causes, we can expect the markets to undergo another sizable correction in 2016 or thereabouts, depending on when the Fed raises rates and perhaps even on whether we get a change of political party in the White House. What should investors do about it?

If we have been following the right investment advice, we would likely not need to make any changes at all. Why? Because such corrections have come and gone time and time and again; every 3.75 years on average, in fact, as cited above. And every time a bear happens upon us, we are always left with great buying opportunities that reward us amply during the bull runs that always follow.

Preparing for the event is much simpler than we realize: don’t buy more than you can handle, don’t use more margin than you can cover, and don’t panic by selling into the correction. If we have not over-extended ourselves by buying too much on margin, we wouldn’t have the need to sell anything on the way down, but would instead have extra cash on hand to buy as prices fall, which increases our gains all the more when the bull returns.

There really isn’t much more to add to that. It’s really quite simple. Use more cash and less margin, and be ready to add a little on every dip.

Rest assured, the Fed will not raise rates if the economy can’t handle them. And remember, each and every bear gets chased away by a bull in just nine months on average… sometimes by two bulls back-to-back.

Joseph Cafariello