Market Timing Models – Studying Past Bear Markets and Crashes for Clues and Setups

I covered the S&P 500 SPDR chart on Thursday and there is no change in the breadth indicators. Well, actually there is. The four remaining bullish indicators, Percent above 200-day EMA for XLK, XLU, XLRE and XLP, moved below 40% to turn bearish. This means all nine index indicators are bearish and all 33 sector indicators are bearish.

The market is oversold, but we do not need an indicator to figure that one out. There is one HUGE problem with oversold conditions right now. Yep, you guessed it. We are in a bear market. Oversold conditions alert us to possible setups in bull market environments, but not in bear market environments. We should simply ignore indicators that are at extremes and  showing oversold conditions for now.

Today we are going to examine prior bear markets and prior declines that exceeded 25%. There are not that many over the last 50 years so the sample size is relatively small. Nevertheless, I think we can learn something and get a better idea of what to expect going forward.

First note that bear markets are not like bull markets. They are often shorter and more volatile than bull markets. notes that there have been 12 bull markets between 1926 and 2019, and 11 bear markets. The bull markets lasted around 6.6 years on average, while the bear markets averaged just 1.3 years. The average bull market returned 339%, while the average bear lost 38%. The chart below shows the Zigzag (20) indicator highlighting price moves of 20% or more in the S&P 500 (invisible) since 1926.

Click here for an article and video explaining the indicators, signals and methodology used in the Index Breadth Model. This article also includes the signals of the last five years.

There are not that many “good” opportunities to short because bear markets are short and full of volatility. As far as I am concerned, we may get two good shorting opportunities in a bear market. Trading is often too volatile the rest of the time. Nevertheless, I will highlight the textbook setups that formed in some prior bear markets.

I will also look at how some of these bear markets ended. No two are exactly the same, but there are some items to watch for in the coming months. First, bear markets often end with a seriously sharp advance that becomes overbought and stays overbought. Second, there is often a re-test of the bear market low. This retest sometimes forms a slightly higher low. Third, there is usually a playable pullback after the initial thrust higher.

Hone the Skills

Before we get started, just a note about the next few weeks. I cut my teeth in the early 80s working at Oppenheimer & Co in Houston, which is a long way from my current home (Belgium). I experienced the 81-82 bear market first hand and got caught 100% short in August 1982. I made money on the way down, got cocky and then got my head handed to me with a 20% surge in 16 days. We will cover this chart a little further down.

I was a young gun then and learned a lot from the experienced brokers. One broker said that you need bear market projects because there was no sense promoting stocks to clients in a bear market. His idea of a project was home remodeling or a new hobby.

We should also consider a project during periods that are not conducive to our trading or investing style. Bear markets and excessive volatility are not my cup of tea. I am not going to suggest building a deck though. Instead, I think this is a good time to step back from the markets a little and hone our skills.

Even though I do not know when or exactly how this bear market will end, I can prepare for that day and have a plan in place when conditions are right.  Here are a few suggestions:

  • Study historical charts to better understand price action and patterns
  • Study indicators and settings for setups going forward
  • Develop a strategy, plan and process for investing or trading
  • Make a short list of stocks that are benefitting from secular trends
  • Read market-related books
  • Try new charting software or websites (gasp!)

These are all on my list in some way, shape or form. In fact, the plan is to roll out a set of educational articles and videos in the coming weeks and months. Today I will look at prior declines greater than 25% for an idea of what to expect going forward. Next week I will cover breadth indicators and offer a ChartList with over 100 customized breadth charts.

Perspective on this Historic Decline

The first chart shows the S&P 500 over the last 50 years to put this decline (crash) into perspective. The 16-day Rate-of-Change exceeded -25% for just the third time. The first time was October 1987, the crash. The second time was October 2008 in the midst of the financial crisis.   

The next chart shows the S&P 500 with moves greater than 25%, up and down. Four are associated with the bear markets in 1973-1974, 1981-1982, 2001-2002 and 2008-2009. The fifth occurred with the 1987 crash and the sixth is underway right now. As we will see in the separate analysis below, there some big bear market bounces 2001, 2002 and 2008.

1973-1974 Bear Market and Reversal

We will start with the 1973-1974 bear market and reversal. While I can chart the S&P 500 for 50 years on StockCharts, I cannot seem to isolate 1973-1974 for a detailed study. Thus, I am using Optuma for this chart. Yes, I am experimenting with other charting platforms. The S&P 500 fell some 50% from January 1973 to October 1974. In between, there was an “oops” moment in October 1973 when the index broke above the 200-day SMA and exceeded the prior high. This “breakout” did not hold as the index moved sharply lower in November. First lesson: beware of an alleged breakout that occurs after the first big decline.  

The bear market ended with a sharp advance and a sharp pullback that held just above the prior low. This is the re-test after the initial impulse move. The index then broke out in January 1975 and then added another 25%. Note that the index was overbought in January 1975 and became even more overbought as the advance continued into early July 1975. After an initial advance from 64 to 96 (+50%), the index then corrected with a 33-50% retracement and RSI became oversold. The index also tested the 200-day SMA. This was the playable pullback.  

1981-1982 Bear Market and Reversal

A nine-month topping process and a big Descending Triangle preceded the 1981-1982 bear market. The S&P 500 broke support in August 1981 and was already below the 200-day SMA. There was a sharp rebound (~12%) after the initial decline and we got our first textbook bearish setup. This bounce retraced around 61.8% of the prior decline, broken support turned resistance and a rising wedge formed. These three characteristics are textbook for bear market bounces and we will see them again. The breakdown signaled the start of another leg lower. Before leaving the decline, note that there was another double digit bounce in the spring of 1982. Yes, bear market bounces can be sharp.

This bear market also ended with a massive surge in the second half of August (20+ percent in 16 days). After a brief dip, the surge continued into October and the index was up some 35% by October 21st (two months). There was no retest of the lows on this breakout. In addition, pullbacks were minimal as RSI bounced off the 40-50 zone from November 1982 to June 1983. This surge and extension were exceptionally strong.

1987 Crash and Slow Rebound

The March 2020 crash compares to the 1987 crash in terms of speed and percent decline. As of Thursday’s close, the S&P 500 was down 26.4% in 17 days. By comparison, the index fell around 31% in ten days in October 1987. Notice that a volatile period followed this crash with five swings that exceeded 12 percent over the next 50 days. This is what we could be in for now (choppy trading until late May). See also the October 2008 crash below.

The 1987 crash reversed with breakouts in January and February 1988, and there were three bullish setups along the way. After the first higher high, the index formed a bullish pennant and broke out in early February. After the February-March advance, the index corrected with a falling wedge. After the move above the 200-day in June, the index corrected back to the 200-day in August. The 1988 advance was quite choppy overall, but bullish continuation patterns and tests of the rising 200-day provided opportunities.

2001-2002 Bear Market

As with the 1973-1974 bear market, the S&P 500 fell around 50% from August 2000 to October 2002. The PPO(20,200,0) turned negative in October 2000 and remained negative throughout this strong downtrend. Despite this strong and extended downtrend, there were three BIG bounces along the way (~20%). These bounces had a big bark, but no bite as each peaked around the 50% retracement. Also notice how the 50-70 zone became the danger zone for RSI. Thus, chartists looking for shorting opportunities can wait for bounces that retrace around 50% and push RSI(14) in the 50-70 zone.

2003 Bottom and Breakout

The S&P 500 endured a long bottoming process from July 2002 to March 2003 and finally broke out in June 2003. This bottoming process was extremely choppy with five swings greater than 15 percent from mid July to late April. The first signs of a bottom occurred in March 2003 with a higher low, surge and small breakout. This was the “retest”. After a small pennant in April, the index followed through with a break above the 200-day. The PPO(20,200,0) then turned positive in May and the index broke its resistance zone in June 2003. As with many bear market ending bounces, the move from mid March to mid June was sharp (+25% in three months).

2008 Bear Market Setups

There were some classic bearish setups in 2008 as the market fell from 1565 in October 2007 to 676 in March 2009 (more than 50%). This marked the third time in 50 years that the stock market was basically cut in half by a bear market. The index broke down in January 2008 and continued lower into March. SPX then bounced with a textbook bearish setup: ~50% retracement, return to broken support and rising wedge. SPX also failed at the falling 200-day in May 2008. The other two textbook bounces are also noted on the chart.

The red shading highlights the crash in October 2008, when the index fell 28% in ten days. This also compares to the March 2020 crash. Notice how trading turned extremely volatile after this crash. The inset image shows the Zigzag (10%) with seven swings greater than 10% during this five-week period. Try to imagine trading during this period. It would not be fun. Price action prior to the crash was quite normal with two playable setups (at least for me). Price action after the crash was way too volatile for mere mortals.

Bottom Line: Volatile Bear Market Environment

As the analysis above suggests, the March 2020 crash best compares to the crashes of October 1987 and October 2008. Volatility remained high for ten weeks after the 1987 crash and for five weeks after the 2008 crash. Prices bottomed with the 1987 crash, but continued lower after the 2008 crash. At the very least, I think we can expect one to two months of above volatility as the news flow, the coronavirus, the Fed, the government and the pundits add to the chaos. Chartists looking for further studies in volatility can look at price action in 2011 (European Sovereign Debt Crisis) and 2015 (ETF Fiasco).

Stay safe and wash your hands

-Arthur Hill, CMT
Choose a Strategy, Develop a Plan and Follow a Process

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