Bear Market Playbook With Vertical Violations

How would you like to be at bat and know the pitch that’s coming? That sort of insight makes all the difference in baseball — and investing.

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How much easier could you manage a bear market if you quickly spotted it and knew how the downtrend would likely to play out? When a stock market correction starts with a “vertical violation,” you’ve got a good game plan based on historical precedent. It gives you an inside edge at protecting your capital.

Bear Market Studies

We have a lot of studies on bear market bottoms. The follow-through day is our preferred signal for knowing when to re-enter the stock market after a punishing correction. While the signal is present early in every bull market, not all follow-through days work. We wanted to understand what set apart prolonged and challenging corrections vs. shorter and restrained pullbacks. Were there factors that could warn us when an emerging correction was likely to drag on for months with multiple failed follow-throughs?

In looking at failed follow-through days, we noticed something about the stock market tops that preceded them. We know what is typical in a stock market top.

Distribution days of higher-volume selling start to pile up. You’ll have some up days but they are overshadowed by the down days. The losses are larger than the gains. Key moving averages are rising due to the prior uptrend, but the index falls enough to meet them. Eventually, the stock market correction gets steeper and can even lead to a bear market. The vertical violation, however, is different.

Vertical Violation Defined

A defining factor of a vertical violation is the steepness of the decline coming off the stock market top. The number of down days aren’t just slightly higher than the up days. They are overwhelming. You might see several days of selling with just one feeble attempt at a gain. At least one of the days down will stick out among the recent action. It’s much larger than any of the days surrounding it. The big down day will often approach a drop of 3% or more.

Finally, the decline doesn’t just meander down to the 50-day or 200-day moving average. It slices through the line. When you see this signal, you can expect at least a couple of months of choppy action and possibly a bear market.

Take the bear market from the last quarter of 2018. The break of the 50-day moving average wasn’t out of the ordinary (1). With a 1.8% drop on Oct. 4, it was deeper than recent action. But the Nasdaq composite had largely been going back and forth prior to that. Still, it was enough for IBD to switch its market outlook to “uptrend under pressure.”

By Oct. 10, the look was very different. As the index sliced through the 200-day moving average (2), the day’s drop was much worse at 4.1%. However, it wasn’t just that day that was concerning. Of the previous five trading days, only one was positive. Even that one day was barely up. This is what a vertical violation looks like.

IBD’s market outlook went to “market in correction” and it was the halfway point in the first of three waves down (A).

Bear Market Playbook

Once you have a vertical violation, there are certain things you can expect of the bear market. The severity of the vertical violation usually needs time to heal. Expect at least a couple of months before a market rally can take hold again. That means your first one or two follow-through days are more failure prone after a vertical violation.

At a certain point in the selling, you should expect a bounce. We started to rally at the end of October and on Nov. 7, we got a follow-through day (3). Nothing looked out of the ordinary as the Nasdaq composite got back above its 200-day moving average line.

However, just two days later (4), the index closed below the low of the follow-through day. This is an early sign of failure. On SwingTrader and Leaderboard, we had light exposure and backed away quickly. Because progress stalled immediately, it was easy to protect capital. As the selling intensified, we saw the second wave down in the bear market (B).

Another Failed Follow-through Day

On Nov. 28 we got another confirmed rally attempt with a follow-through day (5). This day had a larger percentage gain and more stocks seemed to make progress afterward. Rather than an immediate sign of failure, the Nasdaq composite made progress to its 50-day line (6). Then it got turned away in dramatic fashion with a 3.8% drop (7). That started the third wave down in the bear market (C) as the selling intensified.

We had three waves down, a repeating pattern in bear markets, and nearly three months of a stock market correction by Christmas. When we saw a strong rally day off the bottom (8), we had more confidence that our next follow-through day would work. Why? The historical precedent.

History Might Not Repeat But It Rhymes

The vertical violation is visually distinct. So looking at past examples is useful. As the saying often attributed to Mark Twain goes: “History never repeats itself but it rhymes.”

The adjoining table shows 10 vertical violation examples for study from the Nasdaq composite. Some led to a bear market. Others may have been shallow but still had considerable time before starting to rally back.

The examples can be accessed using the change date feature on MarketSmith. Links are included on a few recent dates that have stories, some of them in real time, with marked up charts pointing out the vertical violations. By contrast, you might look at the pullbacks of April and October 2014. These examples are not vertical violations. The selling isn’t as relentless in its severity. And the quantity of down days without a rally attempt doesn’t approach the vertical violation examples.

The Follow-through Day That Ended The Bear Market

Armed with the historical precedent, we had high hopes starting after Christmas (8). In IBD Leaderboard, the exposure was light at the bear market bottom, just 11% invested. One risk of light exposure is that a strong stock market rally can quickly leave you behind. To prevent that, we added a double position of the Proshares Ultrapro S&P 500 ETF (UPRO). The triple-leveraged exposure to the S&P 500 would help us keep up with the market while we added breakout stocks.

On Jan. 4, the Federal Reserve shifted its position on tightening rates and the catalyst led to a follow-through day on the S&P 500 (9). Volume was lighter on the Nasdaq composite so it fell short on that index, but you only need one index to confirm a rally. For January 2020, Leaderboard was up 11.0% vs. 7.9% for the S&P 500 due to aggressive buying after the bear market ended.

The Coronavirus Stock Market Crash

Understanding what a vertical violation looks like and how it plays out can be instrumental in protecting your portfolio during a bear market. With the coronavirus stock market crash, we recognized the vertical violation. SwingTrader ended the first quarter with a 10% gain vs. the 20% loss for the S&P 500. Leaderboard was down just 3.2%, handily outperforming the S&P 500 loss.

It played out in real time on IBD Live and our other products as we saw the early warning signs of the coronavirus stock market crash. Truthfully, we didn’t know how bad the correction would get. And we still don’t know how long the bear market will last. But the historical precedent allowed us to protect our capital.

This article was originally published April 3, 2020, and has been updated.

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