Friday, August 13, 2010

Dow Theory Lesson: Bear Markets

Like bull markets, bear markets can usually be characterized by three phases.

The first is the “distribution” phase, which usually starts in the latter stage of the bull market’s “blow-off” phase. This phase starts with the “smart” investors (institutions and insiders) recognizing that a bubble in prices exists with price-to-earnings ratios well above average historical highs. As prices go higher and higher, the smart investors scale in their sales and are out of the market when the top is reached. Volume in this phase is usually high, but in its final days the tip-off is that volume begins to decline on up days and advance on down days.

The second phase is one of “panic.” Buyers thin out and sellers become more urgent as a downward spiral in prices suddenly accelerates into an almost vertical drop, and volume reaches climactic proportions. After the second phase, it is not unusual to have a long secondary rally that slowly grinds to a low-volume phase that introduces the final sell-off.

The final phase is characterized by sellers who held on through the panic and are now resigned to the fact that prices will head even lower. Business news is now deteriorating rapidly and the penny stocks that had doubled and tripled have now lost all of their gains with many going out of business. Blue chips are still falling, although at a slower rate, but then even they are thrown out with everything else in a final crescendo of selling.

The bear market ends when everything in the way of possible bad news has been discounted and the public never wants to own stocks again.

Not all bear and bull markets are alike, and individual markets may even lack one of the phases mentioned. Also, there is no time estimate for either type of markets. However, since 1950, most bull markets have lasted for three to five years, and bear markets have been as short as three months and as long as three years.

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