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Sunday, October 19, 2008

Three phases of a Bear Market

I have been receiving a number of queries and comments about what to do now, whether the bottom is near, and if this is a good time to start putting some money back into the markets. For many investors this may be the first real taste of a bear market, so these queries need addressing.

To get some idea of what to do next - and I've already voiced my opinion of the benefits of 'doing nothing till we hear from Mr Market' - one should be aware at which phase of the bear market we might be in.

There are three distinct phases in a bear market.  The first phase can be called a 'distribution' phase if you are an enlightened investor, or a 'denial' phase if you are a newbie. Smart investors start exiting the market, 'distributing' their stocks mostly to the late entrants who got caught up in the hype of the bull run.

The consequent fall in the index is looked upon as a bull market correction by the less informed investors, who follow their prior 'buy on dips' successes to buy some more. This in turn causes the first of the bear market rallies which is not supported by the smart investors. The rally peters out making a lower top.

When the second down phase starts, concerned investors begin to realise that this may be a bear market after all and start selling off. Buyers are few and far between. Volumes become lower and the market makes new lows every day.  A few disbelievers still hang in there and think that the market has bottomed.  There is usually a short upward rally which soon fizzles out and the market heads down again.

Now the fundamental news and company results start getting weaker and more negative. Every one becomes fully bearish and stocks are sold at any price leading to a complete 'capitulation' phase. Investors become risk averse and look for safe options like fixed deposits to protect their capital. The stage is now set for the recovery.

A fairly prolonged bottom formation happens now. Prices tend to drift sideways and then marginally down, but at a much slower speed than the earlier two phases. Finally the bear market ends when all the possible negative news gets discounted and smart investors begin to enter for the first or 'accumulation' phase of the new bull market.

So where are we now? We have definitely gone through the first two phases and are probably at the last stages of the final 'capitulation' phase. While no one can say where the final bottom will be, it looks like we are getting pretty close to it.

Is it a time to start buying? As a fairly conservative investor, my take is to wait till the first confirmation of an up move is received. That may mean waiting for 6-8 months more and buying at prices 10-20% higher than what they are now. If you are less conservative and wish to buy now, stick to large cap stocks and be prepared for a longish period of little or no returns.

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