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Ready for a Bear Market Rally?

Ready for a Bear Market Rally?

In history, some of the BIGGEST rallies have occurred in the middle of bear markets.

Look at the dot-com bust or the great financial crisis of 2008, each of them had powerful rallies in an incredibly short amount of time.

So, the big question is: How do you know when they’re going to occur?

Today, Clint Lee and I give you three conditions to look for and the sectors to hone in on.

Click here to watch this week’s video or click on the image below:

Transcript

Ted:

Hello, everybody. This is Ted Bauman here of The Bauman Letter, and of Big Picture Big Profits, our free weekly, actually daily email that we send out. This is our Friday video, and guess who’s here with me? Somebody who hasn’t been with me in a while, that’s Clint Lee over there. Our topic today is bear markets, particularly the options that bear markets present. And I don’t mean puts, I mean that bear markets actually provide some opportunities for profit if you know what you’re doing, if you pay attention, and history proves that.

But before we start that, let’s just review what’s happening. The market is now down. It’s actually a little bit up today. The S&P 500 is flirting with bear market territory. It closed at 18.2% down since its close on January, or sorry, its high on January 3rd. Interesting, Clint, that the high in the market was on the first trading day of the year. It’s all been downhill from there.

Clint:

Yep.

Ted:

Anyway, so that’s what’s happening there. But what we’re seeing is that what started as a tech-driven sell-off is now migrating into real-world stocks, particularly consumer stocks. We’ve seen retail stocks get smashed, and to me it makes no sense that people would wait until they report to sell, because everybody saw this coming. We’re going to get higher input costs, it’s going to squeeze their margins. If you think taking a 25% loss on Target is worth it just because of that one data point, I wonder why you’re in the stock market. It’s certainly a longer-term gain than that. But let’s talk about the short term. Clint, why do you say we’ve got opportunities in this bear market that’s likely to come?

Opportunities in a Bear Market?

Clint:

Yeah, anytime you talk about bear markets, the opportunity you end up being fixated on is the downside. And yeah, you can play the downside with puts, but take a step back. You can play the upside too, because look, some of the largest, most powerful rallies in the history of the market have occurred, have taken place right in the middle of bear markets. And sometimes these are like just huge one day gain, some of the largest percent gains in the history of the market have occurred. Some of them took place in the top 10, have taken place in 2020’s bear market, the 2008 financial crisis.

But it’s more than just big one day pops in the market. I went back and was looking at just some prior instances to put it in context, and there’s a lot of comparisons drawn to what we’re seeing now to the dotcom bust because of tech valuations. And when you go back and you look at a chart of the meltdown of the market back then, all you can see is what looks like that waterfall decline that took place over a couple years. But within that decline, the S&P 500 from April to May, so just over a two month span in 2001, was up 19%. In the fourth quarter of 2001, the S&P rallied 21%. In the financial crisis, the S&P went up 17% from March to May. So right in the middle of the financial crisis you had that big rally there. So even in this episode, go back to March, there was a two week period in late March this year where the S&P shot up 11% once again, just in two weeks.

So one last observation here, a lot of comparisons to the dotcom period, but given what’s going on with inflation and concerns over what the Fed’s moves are going to mean for the economy, a lot of comparisons to the stagflation period of the 1970s. And that was a decade where you go back and look at the Dow Jones, the Dow went absolutely nowhere. It spent pretty much 14 or 15 years trading in a range, there were some epic declines as part of that range, but you also had these huge rallies, Dow was up 49% from June, 1970 to the end of 1972, and then another 64% rally from September, 1974 to early 1976. So once again, just huge one day rallies, rallies that can unfold over a couple weeks or months, but then right in the middle of these grinding bear markets, you can have these rallies that can last 12 months or longer as well.

Ted:

So they rally, and then they fall again?

Clint:

Essentially. I think of it as a countertrend rally. So yeah, if you’re in a bear market and the primary trend is down, but it’s not a straight shot down. You can have these rallies in between. And what you lose sight of, just once again, visually you see the line going down, but you lose sight of those brief pauses, just how big those countertrend rallies to the upside can be.

Ted:

So, you need to pay attention to the trees, not just the forest.

Clint:

Exactly.

Ted:

But so, is this across the board, or does it happen… Is it particular sectors, or is it just something that all stocks experience, or is it just… How do we know?

Is This Happening With All Sectors?

Clint:

Yeah, so a lot of times what you’ll see is the most beaten up groups will be the names that lead the rally. There’s other ways too. You can play relative strength as well, even during, and that’s where my preference is. Instead of looking at the stocks that have been beaten up the most and trying to pick out the bottom, I prefer to use relative strength. Even in the sell off, there’s stocks that might just be trading sideways, that are still hovering near their all-time highs. And then once the market finds that temporary bottom and things start to turn, you can have names moving out to new highs. Like you’ve seen this year in the energy space. We’ve seen it in especially exploration production names. We’ve seen it in a lot of natural gas link names. So there are pockets of relative strength out there to be able to play these rallies.

Ted:

Right. So that mini rally in a sector, that’s understandable given the fundamentals. But the critical thing though, is it’s fine to go back and look at the charts after the fact, but how do you know when this is going to happen? We want to know ahead of time, right?

When Will This Rally Happen?

Clint:

Yeah, right. I mean, look, it’s tough, right? Because the markets can, in these types of environments, they can turn on a dime. And they can turn when the news seems the worst, and you’re sitting there scratching your head. Well, how in the world can the market rally when the news seems so bad? And that’s when you need to be very objective in terms of how you evaluate the market. And that’s why I like to do with a set of indicators that I use, that I’ve been using for a long time to help inform me on what the short to intermediate term trend could be in identifying those turning points.

And some of those things include investor sentiment, so it’s a Warren Buffet saying, be greedy when others are fearful, fearful when others are greedy. Well, look for these turning points that occur when there’s a lot of fear in the market. And we have a lot of fear right now. Things like CNN Money has this Fear and Greed Index, it’s running at its lowest levels in the past couple years. You can look at put-call ratios, so it’s a spike. And the number of puts being bought relative to calls can be indicative of a big spike in fear in the market. And that can help mark a bottom.

So look for signals from investor sentiment, but then I also like to pay attention to breadth indicators as well. And breadth is a just catch all term. It can mean a lot of things, it can be measured over a lot of different periods, but essentially what you’re doing is you’re looking at how many stocks are advancing your relative to declining, or maybe it’s how many stocks are above or below some. Some moving average. And like I said, you can make this as short term or as long term as you want to. But one of the things I look for is when we have the market trying to put in a big rally or the start of a rally, I immediately look to an advance-decline ratio. So how many stocks are advancing relative to declining because that, a big ratio, a big figure there can tell you if institutional investors are coming back into the market. That’s who you need to support. These big rallies and in a high ratio can lead to that.

In fact, this week on a couple of the days, or Friday and earlier this week, a couple days that we have had big rallies, that AD ratio has been around seven to one, between seven and eight to one. So seven advances for every one decline. That’s a pretty good ratio. It’s not one that necessarily tells you’re at the end of a bear market, but that is one that can tell you could see a bear market rally.

Ted:

And presumably, there’s some volume in there as well. You want to see a lot of participation, right?

Clint:

Right. You can look at the same ratios from a volume perspective. There’s a couple ways to use volume. One is, what’s volume doing just across the market on an update? That was the criticism about the big rally that took place on Friday, is that volumes were pretty light on the day. So you want to look at volumes across the board. But you can also, one of the things I look at is the volume in advancing stocks relative to declining stocks. On Friday we actually, if I recall right, we had an incredibly strong number. So just one of those, again, a confirming indicator. And it’s just the intersection of these things. I would not look at sentiment alone as a standalone indicator to tell me a rally could be underway.

Ted:

Well, of course not, because…

Clint:

I look at, yeah, it’s how all these things intersect. The intersection of, okay, we’ve got really bad sentiment so be on the lookout for a potential turn. Well, now you got to start looking for these other signs, other clues that that turn is coming. And for example, [inaudible 00:10:01] that AD ratio. So those things have put me on watch to look for a rally here, even if it is just a bear market rally.

Ted:

Okay. So we’re going to talk about how you’re going to play that rally in a minute, because that’s really what everybody wants to know. But something I spoke about to subscribers to my profits, which serve as actually the video that went out today, this recording is on Thursday, I talked about the effect of options hedging on the market, and how that is actually driving some of these short termers. That’s something that has really become more powerful in the last two years or so. So we’re looking back at history, but how do we disentangle more recent market structure developments from this longer term trend?

Impact of Options Hedging

Clint:

Yeah, that’s definitely something to have in mind, notice as another confirming indicator. Like you said, market structure and how much that’s changed over the last two years, especially how options activity can impact how market makers or dealers are hedging their positions. And this, I believe it is options expiration week. So that is something to have in the back of your mind. But options are also for an individual investor a great tool in these types of markets, just because of how… I mean, you got to have that for, in my opinion, when you get into this kind of a market, you got to have that shorter term, that tactical mindset, and be reflective of the risks. The risks that things can move either for you or against you very quickly. And so having that in mind as you allocate capital to new positions, one of the upsides with options, the risk is that you can lose your premium, but on the other side of it, all you can lose is a premium. So you know how much you stand to lose when you go into that trade.

Ted:

Well, that’s why options are so popular. So I can see a scenario where the signs are pointing toward a short-term rebound fear in… We’re in high fear territory, which all the big proprietary indicators say is actually a bullish sign, because it means it can turn around, and you’ve got advance/decline lines moving in your favor. You’ve got volume on the upside with select stocks. So you’re going to spread your bets, right? You’re going to look for a number of different things, but what specific trading strategy going to use? Because we’re talking about trading here, not investing. What’s your strategy going to be to make money?

 

How Can You Profit From This?

Clint:

Yeah, so I go back to what I mentioned earlier. Areas that I want to look at if a rally does start to unfold are the ones that are showing pockets of relative strength. The ones that haven’t taken as big of a hit during this most recent downturn, preferably ones that are trading at or near their 52-week highs. And there’s indicators you can use out there, whether it’s a relative strength ratio to try to track that, or looking at something like a momentum factor. But there’s also just looking at the underlying characteristics of the stock. One of the things that stands out to me right now, when you talk about what’s happened with Target and the retailers after these earnings reports while earnings revisions are a big thing. So besides looking at just price, one of the areas that I would be fixated on right now is what stocks have come out, especially recently reporting earnings, and are seeing positive revisions in their estimates?

Ted:

Right. Well, some stocks couldn’t get any worse. You know what I mean? For Target, pretty good chance that if you buy Target now you’ll make some money. But what I’m saying is, what’s the actual trade? Are you going to buy options? Are you going to buy the underlying?

 

Clint’s Go-To: Options Trading

Clint:

For me in this environment, I am focusing more on options. Once again, the upshot there is that the amount of money that I spend on a premium is the most I stand to lose. And for me, that type of risk management in this kind of a market where things can move against you very quickly, you may be intent on getting out of a position for a certain dollar stop loss. But with what you see in the markets, you can blow through those levels pretty easily and end up losing more than what you intended to. You can’t do that with an option.

Ted:

Right. So now let’s just sketch a scenario, right? You’re looking at those underlying factors that you talked about, you’re looking at the Fear and Greed Index, you’re looking at advance-decline, you’re looking at trend momentum, you’re looking at RSI, and you begin to suspect that there’s going to be a short term bounce back up. What do you do? You buy short term, short dated options, call options? Or what are you going to do? What’s your strategy?

Clint:

I prefer to go out a little bit. I prefer to have some time premium in my option, so that if a move does go against me, I at least have some of that time premium left in the value of the option. Short term options, they’re attractive for a lot of investors because, just a little move can really impact that option price. But because of that they’re very speculative as well. So my preference is to go a little further out, like a three months minimum, a lot of times out to six months.

Ted:

Right, so you want to keep that delta and the gamma on your side, and not get caught up in those rapid movements that happen towards expiration. So any particular sectors right now that you think might bounce back before others, or are we looking at a broad base bounce back? And I’ll just note, I’ve been looking at some of our portfolios here at The Bauman Letter and our portfolio, pretty huge bounce back in some of these tech names. I was looking at some of the holdings that we have, in some of the more speculative, we got some that are up 20, 30, even 40% in the last couple of weeks. So that’s telling me something, but where are you looking right now for that?

Clint:

Yeah, so I would still be focusing on some of those areas of relative strength, using that relative strength concept that I talked about before. And it’s easy to see what sectors have been holding up here lately. A lot of energy names have that characteristic, have that look about them. Also in the chemical space as well. I’ve noticed there’s quite a few names in the chemicals sector that have been holding up and are trading near 52-week highs. So those two sectors, and materials in general will be on my short list.

Ted:

But those are sectors that I think everybody knows are relatively bullish, I guess. I don’t know if that’s the right term to use, but they have relative strength for fundamental reasons. But what about something like tech? What about the unprofitable firms that did so well that have been beaten down 70%, 80%? Obviously if you can spot that rebounding and put in an appropriate, say call option on that, you could make a lot of money. Do you see us coming up to that anytime soon?

 

What About Tech?

Clint:

Yeah, potentially. That’s a tough thing, is trying to time the bottom, that’s the old saying, you’re trying to catch a falling knife. I think for those names in the tech space or growth space, one of the things I would come back to is that concept around analyst revisions. And that’s one of the things we pay close attention to, is how are the financial estimates, whether it’s the top line or the bottom line looking out over the next couple years, how are those estimates evolving for those companies? So if that’s where your focus is at, those are some of the variables I’d be paying pretty close attention to.

Ted:

And just to reinforce that, some of the holdings that we have, that have had these big bounce back in recent weeks, when I’ve looked at them, it’s turned out because their most recent quarterly said, Hey, our supply chain issues are starting to resolve. In some cases, prices have gone up like in the retail sector, the Targets, the Walmarts, the Kohls, all those guys are getting nailed. But on the other side, you’re starting to see a pullback in prices, you mentioned chemicals. With the exception of fertilizers, that there are some areas in the chemical space, for example, where the big problem during COVID was getting the raw materials, paint for example. But now that’s starting to relax, and I think that’s driving some of it.

Well, Clint, happily for everyone out there, you do have an options trading service that is designed to take advantage of this. Tell us about that before we sign off.

Clint:

Yeah. The service is called Flashpoint Fortunes. It really combines two different types of investing techniques into one. It starts with a quantitative model, a model that ranks out a universe of stocks on factors like momentum that we discussed, on analyst revisions, credit risk, earnings quality, and so on. And then applies a technical system to look for those breakout opportunities on the upside. And it also works on the downside as well. On the downside, we look at bottom ranked stocks, and we play turn, trade those with puts, which we’ve had success doing this year here as well.

Ted:

Yeah. I’ve noticed you’ve had a string of winners. It’s just every other day, I get an email in my inbox saying Clint’s just closed a position with a double digit gain. So imagine that, folks, in the middle of all this. Anyway, that’s it from us. And I’ll be back to you next week. I’m going to be reporting from South Africa for most of the summer, June and July I’m going to be down there, but we’ll also grab Clint and get him back in on Friday’s videos as well.

Anyway, everybody make some money. Subscribe to Clint’s Flashpoint Fortunes service, and of course, click on the links in the description below for that, and as well as The Bauman Letter.

This is Clint Lee and Ted Bauman signing off, we’ll talk to you soon.

Kind regards,

Ted Bauman
Editor, The Bauman Letter

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