Who's Afraid of the Big Bad Bear?

Stocks are just barely in an official bear market, a condition described as a 20% decline from the recent high. As I type this — on the morning of July 8 — the S&P 500 is 19.96% off its Oct. 9th high and the Dow Jones Industrial Average is down 20.5%.

The bear market designation is arbitrary, but it’s not meaningless. Investors, and especially traders, have been trained to act differently in a bear market.

For an example, I pulled off the shelf “How to Make Money in Stocks,” the bible of William J. O’Neil, the founder of Investor’s Business Daily (where I previously worked). William O’Neil is the anti-Warren Buffett in that he eschews buy and hold strategies. With just a glance at fundamentals, O’Neil picks stocks mostly based on technical factors, especially by watching the shape of a stock’s movements on a chart. It’s sometimes called momentum investing, but I know O’Neil doesn’t like that term.

For traders like O’Neil and his disciples, it’s relatively easy to make money in a bull market buying and selling stocks. In a bear market, it’s the reverse: No matter what trading methodology you use, it gets “very frustrating,” Avalon Partners chief market economist Peter Cardillo told me yesterday. Because most stocks keep sliding downhill, “Very little works.”

O’Neil writes: “In the final analysis, there are only two things you can really do when a new bear market begins: sell and get out or go short. When you get out, you should stay out until the bear market is over.”

But how can you tell when a bear market is over? Or when it’s starting? “The typical bear market (and some aren’t typical) usually has three separate phases, or legs, of decline interrupted by a couple of rallies that last just long enough to convince investors to begin buying,” O’Neil writes.

In other words, a bear market is full of head fakes and false signals. Just as it looks like it’s getting better, stocks fall again. Just as the mood is gloomiest, stocks start to recover. Sometimes bear markets are quick and relatively painless; sometimes they drag on for a couple years or an entire decade.

This is the most confusing part of O’Neil’s system (and it’s the same flaw in any trading system that’s not long term): O’Neil provides no easy guidelines for when to jump back in the market, and he admits that he’s made mistakes buying back too early.

Bear markets are tricky terrain for investors. This may not be the wisest move for long-term investors, but it’s easy to understand why some prefer to simply wait it on the sidelines by putting everything in cash.

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