Bear Market Logic

"Histories make men wise; poets, witty; mathematics, subtile; natural philosophy, deep; moral, grave; logic and rhetoric, able to contend." ~ Francis Bacon

Where are stocks headed?  To answer this question, there are certainly many methods that are employed by investors, traders and analysts, such as fundamental analysis, technical analysis, economic indicators, and market sentiment.  But what about logic? 

I believe the line that intersects science, mathematics and philosophy is logic:  Scientific theories, algebraic equations, and philosophical reasoning are all structured arguments and inferences to draw a conclusion based upon what we already know...

Using logic correctly, we will review data-points or factual information available to us, use them to form our logical assumptions, then make conclusions based upon our assumptions...

"Bad reasoning as well as good reasoning is possible; and this fact is the foundation of the practical side of logic." ~ Charles Sanders Peirce

Let's apply logic to draw some conclusions with regard to the projected depth and duration of the current bear market for stocks.  Here's what we already know: 

• Since 1926, the average bear market -- typically defined as a drop of 20% or more -- has lasted 1.3 years. 
• As measured by Standard & Poor's 500-stock index, stocks have plummeted an average of 33.5% during those bear markets and that includes the three "once in a generation" declines:  1) The Great Depression-induced drop of 86%, from 1929 to 1932, 2)The 1973-74 decline of 47%, and 3) The "tech-wreck" fall of 44%, from 2000 to 2002.
• Since the 1930's, all but two bear markets have been significantly milder than average -- with losses generally averaging between 20% and 30%.
• The current bear market decline from the October 9, 2007 peak to the most recent low on July 15, 2008, is approximately 22% and the duration is just over 8 months.

Now for some logical conclusions supported by our data:

• This bear market is not a "once in a generation" decline:  The most recent generational occurrence (2000 - 2002) ended only six years ago, which is much less than a "generation" ago.  We may further logically deduce that a generational decline would follow a generational appreciation in stock prices, which most would agree that the 2002 - 2007 bull market was not a generational climb for stocks. 
• This bear market decline will not be far from average: The generational declines of a few historical bear markets account for a great portion or weight of the average decline, which is why all but two bear markets have been milder than "average."  For an average decline in this current bear market, stocks have approximately 10% more to fall from the most recent lows.
• This bear market duration will not be far from average:  This conclusion is more of a stretch to make but it follows the logic of the previous two conclusions and, for the sake of observation, does provide perspective:  Based on the average bear market duration, this current decline would end (and the next bull market would begin) around January 2009.

Of course, our logic here is not intended to be presented as fact or truth and it certainly is not the basis for prediction or investment decisions -- it is intended as perspective amidst perception -- as logical observations based upon what we already know -- not upon what we do not know.

"The emotions aren't always immediately subject to reason, but they are always immediately subject to action." ~ William James

The perspective, based upon our logic, is that the worst of the bear market may be behind us -- not ahead of us, as our perception would have us believe.  As emotions become more extreme, stock movements reflect those extremes in the form of market volatility, which always punctuate the latter stages of a bear market.  Fear and panic manifest much quicker than that of complacency and greed.

"It is the mark of an educated mind to rest satisfied with the degree of precision which the nature of the subject admits and not to seek exactness where only an approximation is possible." ~ Aristotle

What we do not know is that our logical conclusions will become a reality, for this assumption would be illogical, especially when emotion and perception are factors.  For this reason, I have argued that scientific methods cannot consistently forecast stock prices accurately because it is illogical, if not impossible, to quantify something that is influenced by emotion.  Risk is quantifiable but emotions and uncertainty are not... 

Emotion cannot be measured -- just as love cannot be explained by reason or logic, which is why the prudent investor's methods and strategies will fall short of prediction and market timing, in the absolute sense, and will reflect contentment in the absence of precision and "exactness where only an approximation is possible..."

Related Posts:

Uncertainty, Volatility & the 'Vix'

Going Through the Emotions

Source: Kiplinger.com, Make Money in a Bear Market, Dec. 4, 2007

Comments

[Brian]

Interesting post (as always). One of the things I struggle with when I hear historically-based arguments such as this one (i.e. comparing this cycle to '90-'91,'73-'74, or some other cycle; or the average bear market is down x% and lasts z years), is that it assumes the past is representative of the future. Maybe it is, and maybe it isn't, and maybe there's just not much better to go on.

The 21st century was a unique time in human history in which economic growth was far greater than in almost any other time preceding time period. However, we only have good stock market data for the 21st century.

Therefore, I tend to be concerned that the sample may not be representative of the population. That is not to say that economic growth will forever stagnate from here - in fact, it could accelerate for all I know.

Anyway, just a random musing about a topic that has been bugging me.

[The Financial Philosopher]

Brian:

I could not agree with you more...

While I believe Twain's musing that "history does not repeat itself, but it does rhyme," I would not invest or plan my future according to history.

As I inferred in the immediately preceding "Non-Bottom Callers" post, it is foolish to believe "things are different this time" just as it is foolish to assume "things are the same this time." Perhaps Twain should have added that, "history sometimes doesn't rhyme, either!"

There is such a thing as "abnormal returns..."

My bottom line is that we do not know for sure what the future holds; therefore, we should not predict it.

As I stated in a latter paragraph in this post, "What we do not know is that our logical conclusions will become a reality, for this assumption would be illogical, especially when emotion and perception are factors."

It certainly will be interesting to see what the market does from here and I look forward to observing it... primarily as a passive observer...

Thanks for the comment and for reading The Financial Philosopher...

Kent

[Leonardo]

Indeed "history does not repeat itself, but it does rhyme". It is we that repeat history through our emotional responses to events.

For this reason, we have yet to see true fear in the market (and I'm not talking about capitulation that can be quite easily engineered) The true contrarian trade today is to believe that things will be far worst than what the market believes. Consequently, just because the US has had a depression it does not mean it won't have another. For all we know it could be even worst than that of the '30s.

The first tale tell signs are appearing from the recent rate cuts that are not producing the required stimulus unlike 2002. What most people fail to realise is that events unfold slowly but as a society we demand instant results.It has required nearly 12 months to show that the rate cuts have had no effect. That is why I believe that the truer picture will be evident around mid 2009 where people will finally realise how problematic things really are (and not just in the US. In my mind Europe is in far worst shape). Until then, we may even possibly have a strong rally from the summer-end onwards.
But with all this said and done, the beauty of it all is that the future comes one day at a time....

[The Financial Philosopher]

Leonardo:

I believe your assessment that we have not seen true fear is likely to be correct. The challenge of making investment decisions based upon our assessment of emotions is that fear manifests itself so quickly that investment opportunities are difficult capture.

For this reason, I have suggested and personally practiced the strategy of "selling into strength and buying into weakness" while maintaining a passive core holding, such as a large-cap index fund or ETF.

If I were to write this post again, I may have included Newton's second law of physics, which I believe captures the general behavior of market cycles in terms of motion. The law says, "The alteration of motion is ever proportional to the motive force impressed." The velocity of the preceding bull market was not on the level of the 1920's or the 1990's; therefore, applying Newton's 2nd law of physics, we would expect this bear market to be less severe than those of the 1930's and early 2000's.

To underscore all of my thoughts, I would not make large bets either way and remain mostly passive. Our logic is purely for observation and perspective.

This is not to say that an investor or trader could not make a contrarian bet that the lack of fear in this bear market suggests there is more downside to come.

Recall that our logic suggested that the overall market would still need to fall approximately 10% to reach "average."

This leaves much room for fear...

Thanks for adding to the discussion...

Kent

[Vered]

Interesting!

I consider myself a long-term investor and pride myself on dealing with stock market fluctuations on a purely logical basis. I pretty much assume that I need to keep some of my money in the market, and ignore it except for rebalacing once a year.

[The Financial Philosopher]

Vered:

Your strategy is certainly prudent for a long-term investor.

I believe that we tend to be our own worst enemy, especially in matters involving emotion.

On a separate note, I like your blog...

Cheers...

[Next Gen Politics]

From this article(and I know you don't intend readers to use it as such), I may deduce through logic that I should wait until the market drops another 10% and then restart my investing. Is that sound, considering historical and current events? Anyway, it was an interesting article and fun to read. Keep up the good work, and I hope you'll pop over to our site for a quick look too. Have a great week.

[The Financial Philosopher]

Next Gen:

To answer your question, it is more prudent to invest your money according to your risk tolerance and objectives first, with little or no consideration for current market events.

If you could choose one of three times to invest, Yesterday, Today or Tomorrow, the best of the three, for a long-term investor is yesterday.

What I am saying is that you should invest according to your risk tolerance and objectives as soon as capital (money) is available to put to work (invest).

As for our logical exercise, I would only assume, based upon the averages, that the market is closer to a bottom than a top.

Thanks for the comment. I will certainly take a closer look at your site...

Kent

[Rob]

"As for our logical exercise, I would only assume, based upon the averages, that the market is closer to a bottom than a top."

Do you mean the market is closer to a bottom in time or closer in price? I think it is an important distinction. I'm a technical trader, and we are still in a downtrend. Until I see indications to the contrary, I remain predominately short.

Rob

[The Financial Philosopher]

Rob,

Based upon the logical assumption that this bear market is not a generational occurrence, then the decline in price is approximately 2/3 to the bottom (22% decline, 33.5% average) and the decline in duration is a bit past half-way (appr 9 months in, 16 month avg).

Thanks for the comment. I always enjoy hearing from technical traders.

Cheers...

Kent