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Clues that a bear market is near

Although it’s tricky to predict when a bear market is near, there are clues. Here are some of trader Mark Cook's key signals:

1. Watch how the S&P 500 rallies: Cook paid attention when S&P 500 rallies were weak or failed. He said you can tell the strength of the market more by the way it rallies than the way it declines. He called them “one-day wonders,” meaning you may get a 1%or 2% rally in the S&P 500 (or more) that didn’t carry over to the next day. 

Even more alarming, if a strong early rally reverses direction by the end of the day, Cook saw it as an important warning sign. Typically, in a bull market, strong and healthy rallies continue not just for a day but for several consecutive days.

2. The buy-on-the-dip strategy fails: Buying-the-dip works brilliantly in a bull market, but it fails during a bear market. When the buy-the-dip trade is punished, Cook knew it was time to either switch strategies or risk getting mowed down.

3. Prices are always the last indicator to fall: Cook often said that the public watches stock prices for clues of a bear market, but that prices are the last domino to fall. No one knows what causes a crash or bear market. The catalyst usually comes from a source that no one has foreseen, hitting a market that is already weak. Prices plunge and everyone realizes the market is in serious trouble. According to Cook, the clues were obvious weeks or even months earlier. 

Crashes are not welcome

Cook did not like market crashes because they killed volatility. He often said that crashes are not good for anyone, especially traders. Cook thrived on volatility to make money. He preferred an occasional 10% correction to a crash. He told me he made the most money during corrections and bear markets. 

It also bothered Cook that he made money while so many investors suffered. Short-sellers such as Cook are often despised and even blamed for market crashes. Cook had to deal with being called names and not being invited to share his views on typically bullish financial news shows. 

Cook’s to-do list

Here’s a list of some of the ways Cook was able to thrive during crashes and bear markets. Keep in mind that these strategies are primarily for traders: 

• Sell long positions and move into cash until the storm has passed. 

• Buy puts on the S&P 500. 

• Buy inverse ETFs. 

• Short individual stocks. 

Cook said that the most prudent strategy for many traders is to move into cash or sell stocks to a point where they’re comfortable. Moving to cash is not designed to make a profit but to protect your portfolio and also to be ready to take advantage of future investment opportunities. 

Cook said that you must know how much pain you can accept (i.e., risk tolerance). If you can handle a 30% or 40% downturn, then stay the course. If not, move to the sidelines. 

Another key to surviving bear markets and crashes is diversification. If your portfolio is diversified, there is no reason to panic, which is what many people do when the market loses 20% or more. 

Cook left other valuable nuggets of trading wisdom: “One thing that must be stressed,” he wrote, “is that bear markets are not bad. Think of corrections and bear markets as trading opportunities. There is a pause in buying and then an all-out run for the hills when the grizzly is on their heels. When a bear market arrives, people descend into irrational thinking and actions. It always happens.”

He added: “Take the opportunity to learn about downtrending markets. You should also prepare for the next bull market that will emerge once the bear market ends. That’s when you can really do well. While trading on the short side involves good timing skills and experience, it’s easier to trade in a rising market.”