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Bear Market Ahead? Beware of 'Flash Crashes' and 'False Charges'

When I was a Boy Scout backpacking in the Sierras, my troop assigned shifts of scouts at night to watch for marauding bears on the perimeter. To scare them off, the sentry clanged a pot or made some raucous noise. That simple response seemed to work fine—the fourfooted opportunist, however hungry, usually got the hint and strolled off in search of less noisy campsites with a hint of food in the air. (Little did I know this would eventually be helpful information for investors!)

(Estimated reading time: 3 min 11 sec)

On a recent trip back, I came upon what appeared to be an experienced backpacker. I wondered aloud whether the pot-clanging technique still worked. It did not, he countered; bears today were quite used to that behavior. Now you need to holler and throw rocks at them, he said. He crisply added an important disclosure, “But beware of the false charge.”

investors

Bear!

As we look at capital markets today, we must worry about another type of bear that tests the courage of our convictions. I am not referring to the traditional bear associated with steadily declining stock prices driven by deteriorating fundamentals, but one that suddenly explodes on the scene with, er, barely the slightest provocation. After a quick purge of market confidence, prices recover speedily and fears subside. These “flash crashes” are predictably unnerving, particularly for the casual observer or inexperienced investor.

A look at recent historical examples of these sudden market dislocations that proved to be “false charges” can help to illustrate what defines a temporary crash versus a more self-sustaining, systemic move like the one that followed the Global Financial Crisis in the mid-2000s. Knowing this distinction, investors can be better prepared to protect their own capital and position themselves for a safer investment experience.

These false charges that threaten market collapses will continue to test investor resolve. To that end, investors need to monitor evidence of complacency combined with leverage embedded in the markets.

Only in hindsight can we conclude whether a sudden correction of, say, 10% in a given market is a temporary setback in an otherwise rising bull market. And a bear market (typically referring to a drop of 20% or more from a high) can get its legs from an initial event that seems isolated and not systemic. The bear market of the early 1990s can trace its initial descent to the failed United Airlines buyout. For that reason, it is always important to know where you stand and how well you can hold that position, particularly as it relates to leverage and counterparties that can force you to move. With less baggage, one is more able to rebalance and invest in new opportunities without being overtaken by the bear market, whenever it may suddenly appear.

Remember our bear in the woods testing our resolve to stand our ground? What happens if the bear realizes the false charge is not enough anymore? Because a bear can outrun any human being, uphill or downhill, wildlife experts say to never run from a bear. So be mentally prepared to stand your ground. And calmly find that bear spray canister that your worry-free companions laughed at earlier … just in case a false charge becomes more than that.

The same rules apply to the bears investors need to be concerned about. Most of them, familiar with traditional market cycles, have steeled themselves with broad diversification and rebalancing plans, among other long-term risk-mitigating techniques. When investors have set aside sufficient reserves to endure a potential bear market, time is generally everyone’s friend as economies and markets eventually heal.

With the added risk of false charges, investors need to be both defensively positioned at all times and keenly aware of their surroundings. If their reserves have become increasingly thin, time may no longer be their friend (either during false charges or traditional bear markets); the smell of too much leverage and illiquidity can eventually invite the next hungry bear into their campsite.