STAGE 1: The first factor I observe are the rallies. If the market does not rally strongly and even better, if it cannot hold its gains, this is a clue the market is wounded. It will be vulnerable to further injury if there are lower lows on the chart.
STAGE 2: I am suspicious if there is a lifeless rally in a low-volume environment. This tells me the institutions are not willing to buy. Since institutions are generally a herd and they watch their peers closely, if the entire pack doesn’t follow in lockstep immediately, the rally falters. You will hear people say, “This time is different, and history won’t repeat itself.” But history always repeats itself. One of my rules is to study past history so you aren’t doomed to repeat those consequences unprepared.
STAGE 3: The rallies are tepid and weak, have no energy, and are very negative. That’s how bear markets start. It usually starts off slow and goes faster and faster like rolling down a hill, and then you have an avalanche. You may then lose 50 or 60 points on the S&P 500. After a greater than 3 percent correction, the market should be able to mount a meaningful reflex move. If not, then that is a red flag. For example, if there is a 4 percent correction, but the market is unable to bounce back at least a half (or 2 percent in this example), the bear market has arrived. I also look at the speed of the bounce. In a mature bull market, the market will be unable to bounce back quickly or with any zeal. If it cannot bounce back (retrace) at least half of the bounce, that’s a red flag. The bear market is here!
STAGE 4: I also look at what the charts are telling me. A lower low on a chart tells technicians that the mood of the once invincible market is vulnerable. Technicians who study charts believe that if the market closes with lower lows, buyers will start leaving. Therefore, the first clue comes from the chart, and technicians are often the first to see that the first pullback is severe.
The stubborn bulls hold their position while sweat beads appear on their brow. They say to themselves, “I can’t sell here.” The longer they are in the black (profitable), the more staying power they have.
STAGE 5: During this stage, the market begins to accelerate to the downside by eroding 20 to 50 S&P points every three days, while on the plus days, the market only goes up by single digit S&P points. The move downward occurs quicker while the rallies are labored and slow. At this stage, bulls are still buying on the dips, but not as enthusiastically. Therefore, the volume during declines is increasing while the rallies are not as energetic. Nevertheless, most bulls are not thinking of selling. It will take a little more convincing before they reach the selling stage (usually when it’s too late).
STAGE 6: On the chart, the market makes a lower low for the entire quarter or hits a double-digit correction. You will see a stair step of lower highs and lower lows that persists. Volume will increase but has not spiked yet. Time has become an enemy of the bulls. Now that portfolios are down by 15 or 20 percent, bullish investors are thinking of selling. A double-digit decline causes huge redemptions. Even money managers are thinking of selling as redemptions hit. Double-digit declines trigger more mutual fund redemptions.
STAGE 7: Institutions are starting to lighten positions because they fear investor withdrawals. The negative quarter irritates investors, which is the first hint their mood is changing. Eventually, they will move from complacent peacefulness to terrified panic, but that takes time. Stubborn bulls have not liquidated their positions, but investors are buying less. Eventually, the market will give up all of its previous gains.
STAGE 8: The news is becoming more of a factor. As the bear market picks up steam, there is less good news. Economic releases are now viewed with more skepticism. Analysts are concentrating on less stellar numbers while ignoring good news as inaccurate or suspicious. The scale is now tipping towards terrifying panic, but stubborn bulls still hold their positions even though sweat beads become torrents.