Trend-Following in Bear and Bull Markets: There’s a Big Difference

One of the most effective trading strategies in a bull market is trend-following.

Trend-following is a method used to catch sustained movement in a stock. It is focused on catching the “meat of a move” rather than predicting tops, bottoms, or turning points. It is based on price action and technical patterns and avoids predictions and fundamental analysis. It is reactive rather than anticipatory.

The essence of trend-following is that the crowd of investors is right most of the time, and it pays to run with the herd.

Many traders that embrace trend trading in a bull market tend to abandon it in bear markets. Instead of riding the trend, they become much more anxious to call bottoms and turning points. Pundits and the business media talk about nothing other than bottoms and bounces in a bear market.

This difference in trend-following in bear markets is understandable because bear markets are not simply the inverse of bull markets. Stocks tend to go up much differently than they go down. An old saying sums it up pretty well: stocks take the escalator up and the elevator down. The market tends to fall much more suddenly and abruptly than it rises. Bear markets are often marked by crashes, with a huge drop in just a few days.

Another characteristic of bear markets is that there tends to be substantial counter-trend moves. The big bounces occur in the worst markets because market participants are not positioned for them, plus there is a strong tendency to squeeze shorts. These counter-trend bounces make trend-following much more difficult because they will trigger reasonable stops. Trend-followers look to exit a trade when the trend shifts, but it is much harder in a bear market to distinguish between a turn and normal volatility.

Trend-followers recognize that they are very likely to incur losses at market turning points. Because trend-following is reactive rather than anticipatory, there is no guessing about a turn before the price action reflects it. Trend-followers expect to be holding long positions at the top and to be holding mostly cash at the bottom.

Trend-Following in Bear Markets

One of the other major differences in trend-following in bear markets is that many traders and investors are mostly long only. They aren’t substantially shorting. They tend to stay safe by holding very large cash positions.

The problem is that when traders hold extremely high levels of cash, they tend to become bored and want to do something productive. That isn’t a problem in a bull market when trend trading is working, and there are plenty of great opportunities. In a bear market, trend traders have to sit and do very little unless they are engaged in shorting. They often become counter-trend bounce buyers because there is nothing else for them to do.

Trend traders always need to cultivate patience, but it is much harder to stay patient in bear markets when the drops are much more sudden and abrupt, and the bounces are much bigger. There will be an itch to stay active, undermining many of the benefits of trend-following that are readily apparent in bull markets.

If you are employing a trend-trading approach, it is important to recognize how its application will differ in a bear market. You must not be enticed by the bottom calling game that will dominate the market coverage in the business media. Trend-followers don’t try to call tops in a bull market, and they don’t try to call bottoms in bear markets. They let the price action determine whether they should hold stocks or not.

The overall market trend is currently down, and we are in a very obvious bear market. Trend-followers should be short or standing aside and waiting for better chart development.