Profiting in a Bear Market – Part 4

This latest series of posts is taking a look at how the MultiStage Trading System, used to manage my Covestor.com model, performs during bear markets… those ugly down-trending markets that cut through retirement accounts like a sharp axe through a marshmallow. Most are content to just tread water during those times.

In our last post we saw how the MS System performs quite well in bear markets because of the extreme volatility. In fact, frequently the performance is even better than during the bull markets. So let’s make that comparison a little more directly. Again a refresher about when the bull and bear markets begin and end. Over the past 15 or so years, based on our definition in part two, we’ve seen five distinct market phases:

• Bull: February 1995 to November 2000
• Bear: December 2000 to July 2003
• Bull: August 2003 to January 2008
• Bear: February 2008 to November 2009
• Bull: December 2009 to March 2011 (still going!)

As before, these numbers include no commissions or slippage, and are not attainable in the real world (mainly due to liquidity factors, but for other reasons as well). As raw output they are instructive, however, and here’s how they look.

As I told the story in the last post, volatility rising quickly in the bear markets is really the reason that this system works well. It thrives on rapid and exaggerated price movements, which are common in down-trending markets. Short trades are a moderate factor, and there are subtle differences in the average return per trade. But they can’t explain the sizable difference in performance. The big differences are in the number of trades per month, which is also reflected in the “Exposure” line. More trades = more profit!

I have to point out a nasty anomaly in the tests above. The year 2000 was a “topping” year for the market. Because of the topping action and choppiness during that year, the return from our system was enormous, and probably a true outlier that will not be repeated. This is an example, however, of how volatility based trading systems can even do well in transitioning markets. That being said, I’ve backed up the dates for that bull market to make it more realistic. Here are the actual numbers including this strange and volatile year.

You would think that a primarily long trade system would excel in bull markets, but in this case it’s quite the opposite. This study has been helpful for me, and I have a few ideas about how to perk that up. In any case, there are still a couple more installments that I will do on this topic, including in the next post: What happens during a “black swan” event?

Good Trading…