Y L F M A E T Team-Fly® Bear Market Investing Strategies WILEY TRADING SERIES The Psychology of Finance, revised edition Lars Tvede The Elliott Wave Principle: Key to Market Behavior Robert R. Prechter International Commodity Trading Ephraim Clark, Jean-Baptiste Lesourd and Rene´Thie´blemont Dynamic Technical Analysis Philippe Cahen Encyclopedia of Chart Patterns Thomas N. Bulkowski Integrated Technical Analysis Ian Copsey Financial Markets Tick by Tick: Insights in Financial Markets Microstructure Pierre Lequeux Technical Market Indicators: Analysis and Performance Richard J. Bauer and Julie R. Dahlquist Trading to Win: The Psychology of Mastering the Markets Ari Kiev Pricing Convertible Bonds Kevin Connolly At the Crest of the Tidal Wave: A Forecast for the Great Bear Market Robert R. Prechter BEAR MARKET INVESTING STRATEGIES Harry D. Schultz Copyright # 2002 by John Wiley & Sons Ltd Baffins Lane, Chichester, West Sussex PO19 1UD, England National 01243 779777 International (þ44) 1243 779777 e-mail (for orders and customer service enquiries): [email protected] Visit our Home Page on http://www.wiley.co.uk or http://www.wiley.com All Rights Reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except under the terms of the Copyright, Designs and Patents Act 1988 or under the terms of a licence issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1P 9HE, UK without the permission in writing of the publisher. 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Contents 1 Introduction 1 Part I THE BEAR BACKGROUND 7 2 Overview 9 3 History of Bear Markets 17 Part II ECONOMIC SETTING FOR BEAR MARKETS 29 4 Guideposts for Bear Markets 31 5 Globalization, Terrorism, and Foreign Investment 39 Part III STRUCTURE OF BEAR MARKETS 43 6 Secondary Reactions 45 7 Bear Market Legs 52 Part IV TOOLS FOR MEASURING BEAR MARKETS 57 8 Tools to Help You Recognize and Survive a Bear Market 59 9 Tools that ‘‘Change Shape’’ in Bear Markets 74 10 Cycles Study: A Useful Market Tool? 78 11 Chart Reading and Interpretation 83 Part V MONEY-MAKING TACTICS 89 12 Preservation of Capital during a Bear Market 91 13 Short Selling 101 98 14 Strategies for Making Money Even If You Guess Wrong 108 15 Rules for Being a Flexible Investor 115 16 Defensive Investments that Allow You to Sleep Nights 119 vi Contents Part VI THE EMOTIONAL ASPECT 127 17 Human Psychology in the Marketplace 129 18 Contrary Opinion 137 Part VII PREDICTIONS AND CONCLUSIONS 143 19 The Past is Prologue 145 20 Epilogue 155 Glossary of Terms and Tactics for Market Mastery 159 Resources/Recommended books, newsletters, data suppliers, 168 chart services Index 175 1 Introduction ‘‘History never looks like history when you are living through it. It always looks confusing and messy, and it always feels uncomfortable.’’ John W. Gardner, 1968 Over the last 20 years, investors have increasingly come to regard investing in stocks about the same as putting money in the bank—except they got a higher return. This belief became so pervasive that, as recently as 2000, the govern- ment in Washington was still talking about putting part of the Social Security account into securities in order to earn a higher return. After the Nasdaq crash, that plan was quietly dropped. Even investors who researched stocks before buying them either mostly used computer programs that rely on past action repeating more or less exactly in order to predict future buy or sell points, or they used Internet advice which in many cases was nothing more than thinly disguised sales pitches. There is an old adage which says that knowledge can be communicated but wisdom has to be self-taught. I hope that, by the end of this book, you will have enough knowledge to evolve your own market wisdom. With the coming of the Internet, investors were so focused on acquiring the latest information on securities that many never bothered to learn how that information could be best used. And just as many of us have lost the ability to spell correctly or do simple arithmetic because we rely on spell checks and computer calculators, so investors who rely only on the Internet for investment know-how have never had to learn the basic signals to judge where markets will go next. Even more dangerous is the assumption that prediction is a scientific process, whereby if 2 Bear Market Investing Strategies you have the right piece of software that correctly predicted market turning points in the recent past, it would certainly be able to predict the future. But market analysis is not a science; it is an art, using intuition and experi- ence to make sense of evolving data. Past patterns may at times not have their usual relevance for future predictions. I have been writing an investment newsletter for 38 years, and I seem to be on virtually every investment mailing list there is. During the last 5 years of the 1990s, I was inundated with junk mail from software companies claiming to have the key to future market success, based only on their program having called turning points for a few prior years. These software packages used such phrases as: ‘‘fully automated trading software,’’ and ‘‘built-in portfolio,’’ implying that all you needed to make money in the stock market was knowledge of how to operate their software. Until the mid-1990s, analysts on financial news programs did useful research and offered informed opinions of where markets in general and specific stocks were likely to go. But increasingly over the subsequent years those same analysts concentrated ever more on being entertainers, as all business news programs became little more than infomercials for their advertisers. The focus became less to seriously inform and more on keeping the viewer watching so the advertisers would have an audience. But then markets topped out, Nasdaq crashed, and the war on terrorism gave the media permission to use the word ‘‘recession,’’ without being accused of ‘‘talking down the market.’’ Investors were left wondering what to do with stocks that in many cases had already lost a substantial portion of their value in the prior 2 years. Their ‘‘magic bullet’’ software programs failed them, and they lacked basic market know-how, or how to invest in what appears to be the early stages of a protracted bear market. This book is designed to upgrade investors’ knowledge with the basics of how to make investment decisions, with particular reference to bear markets, bull market corrections and recessions. But simply knowing how to make respectable buy and sell decisions is not enough. Nobody in the history of Wall Street has ever guessed right all the time. It’s therefore necessary not only to decide how to predict market direction, but what strategies to use to minimize losses when you guess wrong, and maximize your profits when you are right. The ultimate decision for your investments is made by you. Over the nearly 4 decades I have been advising clients, there have been many times when I would give the same advice to three people, and one would make money, one would break even, and one would lose money. However good the advice we receive, we always inject our own judgment into the equation. In this book, we will discuss how best to make your own informed decisions. A key principle of technical analysis is that there are certain recurring Introduction 3 patterns of investing behavior that can be charted. But no technical tool works all the time. Though history does seem to repeat itself in a general sense, it never repeats exactly, so no one model of past action, be it a war, inflation, civil unrest, or a bear market, is sufficient to ascertain what the future will bring. After the September 11, 2001 attack on New York and the Pentagon, advisors rushed to predict future markets, based on what the Dow Jones Averages did in the Gulf War, or the Vietnam War. But the war on terrorism is unlike any war in the past. The recession of 2000 seems likely to have variations from a number of past recessions. The best way to use the past for future projections is to have as much history as possible of past events: market averages, individual stock groups, technical indicators such as Confidence Index or advance/decline lines, wars, govern- ment monetary intervention, etc. Then check for similarities to what is happening today. With this data, we can then build a mental big picture for possible future market direction based on elements of as much history as possible, which taken together form a totally new paradigm.