Recovery or Bear Trap?
After a week of stock market carnage, it looks like stock prices are bouncing back. Is this the start of a recovery, or yet another bear trap which sucks in unwitting investors, only to fall further? This blog posting helps you tell the difference.
What is a Bear Trap?
A bear trap is when there is a sudden, short term recovery within a bear market. Investors think that it is the start of a recovery and start buying stocks, then there is a sudden drop and the bear market shows that it is still in force.
Another term for this is a dead cat bounce. If you drop a dead cat off a building (note: don’t try this), the fact that it bounces once doesn’t mean that it has miraculously come back to life.
A bear trap occurs because the market will not always continue to move in one direction. The reaction against the primary trend can be mistaken for a change in trend, while in fact it is just market noise. The magnitude of the movement is caused by investors trying to pick a market bottom.
Picking a Recovery
When the market recovers, there is a change in long term trend. A one or two day increase in prices is not a change in trend, that could be just random noise, or a reaction.
A change in trend means that the market has definitively changed from a bear market to a recovering bull market. A bear market has lower lows and lower highs, it has more stocks declining than advancing, more sellers than buyers, it has the long term moving average pointing downward. A bull market is the exact opposite of this.
A bull market will show increasing trade volume as more and more investors re-enter the market.
The important thing is to not try to pick a market bottom. Many traders buy because they think that a particular stock can’t go any lower. Well, in fact a stock can go to zero. This is unlikely, but the events of this bear market show that it is impossible to pick a market bottom by simply looking at a few day’s price increases.
To pick a recovery, you need to find when the trend changes direction. You can do this by using a technical tool (such as Loess smoothing as discussed elsewhere on this site). This tool is an adaptive noise filter which exposes the underlying trend by removing random short term price movements.
If you are into charting, you can look at the chart and confirming a technical change in trend. To do this, draw a trend line along the upper points of the price chart (so that the line doesn’t go through any points on the chart). When the price goes back up through the trend line, this is indicative of a change in trend.
Another way is to use moving averages. This will delay the notice of the change in trend (compared to a more advanced tool such as Loess smoothing), but once the 20 day and 150 day moving averages turns up, this is an indication that the trend may have changed.
Conclusion
It is too early to say that the recent upswing is the first sign of a market recovery. There is no change of trend yet. In my opinion, the market will continue to be volatile, which will hurt any bulls that re-enter early.
If you want to try to pick a market bottom, then go ahead, but there are substantial risks, and it is possible that the market will fall further. There is plenty of opportunity to profit once the change of trend is confirmed, so there is no need to jump straight back in.
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