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Dr. R.H. Rusli
CITI Institute


Bear Markets Are Inevitable-Don't Fight Them; Use Them

As we have already seen, the stock market is constantly fluctuating; it never stands still for very long, but is constantly reflecting the shifting pressure between buying on the one hand and selling on the other. It not only changes from hour to hour, day to day, and week to week, but also fluctuates in major cycles. These major cycles comprise bull and bear markets of substantial duration and extent.

No bull market lasts forever. Inevitably each bull market is followed by a major reversal, or bear phase. Bear markets are as unavoidable as the proverbial "death and taxes." Since they recur every so often, the only sensible thing to do is to avoid fighting them. Instead, you should adjust your investing and trading program to the bear trend advantageously. It is possible to ?use? the bear market, even to make good profits out of it.

Watch for Bear Market Signals
We have already learned that bear markets usually start violently, with a sharp, sudden break, involving large declines on heavy volume. While it catches many people-including some professionals -by surprise, the bear market seldom fails to give some warning signals that an informed observer can detect.

Your first defense against a bear market is to keep alert for the warning signals that precede nearly every major break. When you see these signs multiplying, it is an alarm signal to begin taking defensive action. It is plainly time to begin lightening your stock holdings, and to prepare for the coming storm. The first steps should be to begin weeding weak and speculative stocks out of your portfolio. These issues, usually the last to rise in a bull market, are also the most vulnerable in a bear phase.

Secondly, it is time to begin converting paper profit into capital gains. Toward the peak of a bull market, many investors have accumulated large paper profits on their holdings, but many are loath to cash them in because of the prevailing belief that the market is going still higher. Bullish sentiment is so rampant that it is hard to think of selling under the circumstances.

But, "No one ever went broke taking profits" is an adage that is as valid as it is old; and while you may take the chance of getting out of the market too soon, this is still preferable to getting out too late. Paper profits quickly vanish, giving way to losses, once the break comes.

Of course, few people can get out completely at the very top (and when they do, it is almost entirely a matter of luck). But you can begin averaging your sales to get the advantages of selling at different stages near the peak.

Thus, when the break does come, you will be in a strong position, with large cash balances on hand, ready to reinvest when the time is right.

If You Get Caught in the Break
But suppose you have missed the chance to sell before the break. (This can happen to anyone, including the professionals at times.) Suppose that the break has just occurred-with the unmistakable sharp declines, heavy volume, wide-open breaks in key stocks, and so on.

Under such conditions, there is no point in fighting the market. You "can't argue with a trend" is another old Wall Street maxim. The safe course is to get out of all trading stocks and to do so as quickly as possible.

Strangely enough, no bear market within memory has ever occurred without a great deal of argument among many "experts" as to whether the initial break was the start of real bear market or just a "technical" correction.

While there are such things as technical corrections, or temporary reactions in a rising market, they seldom have the same characteristics as the start of a bona fide bear market. Unfortunately, nobody can be sure about them until after the fact.

Just after the big break of October 29, 1929, there was an attempt to "rescue" the market. Some of the biggest names in finance stated that the decline had "gone far enough," that it would be "checked," and that they were going to support the market. Their efforts were heroic and costly, but what followed is history too well-known to repeat here.

The moral is clear: You can't fight a bear market. Instead, adjust to it, and make it work for you.

1.Watch for Secondary Rallies

2.There are two ways of making money in a bear market.

3.One way is through trading for "secondary rallies."

Bear markets occur in several cycles. The first phase usually is the most violent - heavy liquidation, sharp price breaks, a rush to get out of stocks. This may last anywhere from a few days to a few weeks.

But, after a while, the selling spends itself and the downward move starts to lose its momentum. By this time, the market is down far below its previous bull market peak. For example, by the 5th of December, 1998 the Dow Jones Industrial Averages closed at 9788.31 down by 198.75 points from the October 26, 1998 close of 9987.06.

Finally, a point is reached where the market begins to steady itself, liquidation dries up, and a firmer tone develops. In nearly every such case, the ground is being prepared for an intermediate or secondary rally. Such rallies do not mean that the bear market is over, but they do reflect a temporary relief from selling pressure.

Under such conditions, the market frequently recovers from one-third to two-thirds of its previous decline. What happens is that those who have "sold the market Short" on the decline are now buying back their short sales and short-term traders are buying stocks for a quick turnover. (See page 5 for more detailed description of short selling).

Such rallies may last for a few days or weeks, seldom more than a few months. But they can over a fair amount of ground and thus offer trading opportunities. For example, in December, 1998 the DJIA recovered from the December 5th low of 9788.31 to close the year at 9850.86 for a gain of 62.55 points. The market similarly rallied in February and March of 1998 when it rose from a low closing price of 9803.90 on February 11 to a high close of 9891.66 on March 13, before resuming a downward trend to reach the low closing of 10577.60 on December 6, 1999.

Therefore, after the bear market starts, watch for the initial decline to spend itself. (Eventually it will.) After it does, you can begin rebuying for an intermediate rally, but remember that this is a short-term trading proposition, and not an ?investment? for the long pull.

Special Situations
There may be several such secondary rallies before the bear market finally exhausts itself. After the first or second rally, the market may start downward again, or it may run into a period of dullness.

About this time, one particular type of "special situation" begins to present itself. Such special situations are stocks in a much stronger position than the rest of the market. It is not uncommon to see such stocks rise impressively while the rest of the market is still heavy or dull. Sometimes this is true of a group of stocks rather than just one or a few issue.

Gold Stocks-Sometimes a "Buy" in Bear Markets
Still another way of realizing profits in some bear markets has been to purchase gold stocks. We would like to stress that this technique works sometimes, but not always.

Gold stocks frequently rise in a bear market, especially if the bear market reflects a period of worldwide economic uncertainty. This is so because gold has traditionally been viewed as a universal store of value, with a feeling of stability about it.

Knowing that people turn to gold in times of uncertainty, some traders made fortunes in 1929 by buying Homestake Mining just after the Crash. While the rest of the market melted away, Homestake rose from 65 to a peak of 544 in 1936. Of course, an added reason for this was an increase in the United State official price of gold from $20.67 a troy ounce to $35 a troy ounce in 1933.

The free market price of gold has shown a dramatic price increase since 1971 when the U.S. stopped converting dollars into gold for foreigners (this was in response to a "run" on the dollar). Thanks to increase worldwide economic uncertainty and rampant inflation in the industrial countries, the free market price of gold broke through the $100-per-ounce level in 1973, topped $ 190 in 1974, surged through the $280 level in June of 1979, and went over $850 in January of 1980. (The gold price then dropped back, to below $500 in early 1981, and has fluctuated mainly in the $300-$450 range since then.)

The above events directed many American investors toward gold stocks.
In 1973, while the stock market was in a bear phase of the cycle, gold stocks were exhibiting strong, dramatic gains. Barron's Gold Mining stocks index rose from a low of 144.08 to close that year at 386.36

But the gold-stock market is highly emotional and often moves in unexpected directions. For example, many people thought the price of gold would rise dramatically when American ownership of the "barbaric metal" became legal on December 31, 1974. Instead, the price began a long downward slide. Result: the gold stocks fell in price. Then came the long, irregular climb.

You will have to size up the situation in each bear market to see whether the gold stocks look good. There is no universal rule to apply in buying gold stocks. A few words of caution: Some gold mining companies are no longer important operators in that field. Their gold deposits may be running out, or their gold business may be less important than their other operations.

Those who wish to buy gold itself should be aware that gold fluctuates widely, does not produce an immediate income return, costs money to store and to insure, and is subject to sales taxes. In the long run gold and stocks may not be the right investment vehicles for small traders.

Dynamic Profits Through Short Selling
Thus far, most of what we have said pertains to the purchase of securities on a "long" basis - that is, buying a stock for investment or trading purpose. There is, however, a special transaction whereby one sells first and buys later. This operation is known as "short selling." The most dynamic way to realize profits in a bear market is through short selling.


How Short Selling Works
The actual transaction of "shorting" a stock is quite simple. You contact your broker and tell him that you want to sell 100 shares of XYZ Corporation "Short." He will then arrange for you to borrow the stock. This can be done in a number of ways: 1) his own firm may lend you the stock; 2) his firm may help you borrow the stock from another of its customers; or 3) he may go into the "loan" market (which is a professional group in Wall Street) and borrow the stock for a small premium which you have to pay the lender.

Before you determine to short a stock you should check the availability of loanable stock and the premium that you might have to pay.

When the loan of 100 shares of XYZ Corp. has been completed, your broker will then sell the stock for you in the market. From there on the transaction is treated like any other sale of stock with your broker using his firm?s "floor" facilities to sell the stock as if it were an ordinary "long" sale.

Under present Securities and Exchange Commission rulings, a short sale on any registered exchange must be made at a price at least 1/8th of a point above the last different price at which a regular way sale made on the same exchange.

In the parlance of the Street, this described as "waiting for the uptick." This is now required by law in order to prevent a practice-which was very prevalent years ago-of bears "raiding" the market. Such ?raids? often set off a chain of liquidation that resulted in widespread damage.

Because a short sale is also credit transaction -you are borrowing stock with a promise to replace it with an equal amount in the future -you must demonstrate to your broker that you have a good credit standing. This is easily done by opening a margin account.

A margin account gives you the right to finance a certain portion of your stock purchase through your broker. The amount that you have to put up is called the "margin." Today's margin requirement is 50%. That is, you can buy $10,000 worth of stock by paying $5,000 and borrowing the remaining $5,000 from your broker.

Thus, if you want to short a stock you must have an amount of cash equal to 50% of the value of the stock you sell short, or stock equal to 100% of the value of the shorted stock on which you can borrow 50% in your account. The need for such margin the stock in the event of a price increase.

Covering the Short Sale
A "short" position is not something that can be entered into lightly and forgotten. On the contrary, it requires constant vigilance and attention, because the short position must eventually be "covered," or bought back for delivery to whomever the original shares were borrowed from. Of course, it is the short seller's hope that he will be able to "cover" (buy back) at a lower price than that at which he sold.

If the short seller was correct in his calculation and his hopes are realized, he "covers" his short position at a lower price. His profit then is the difference between the price at which he sold short and the price at which he "covered," just as the profit in a "long" transaction is the difference between purchase and sale.

But not all short sales work out profitably. Just as one can lose heavily in a "long" transaction, so there is risk in short operations. In fact, the theoretical risk is greater on the short side, because the most one can lose in going "long" is the price of the stock, whereas there is no telling how far a stock could potentially rise after the short sale has been made.

All of which emphasizes that short selling is an requiring much planning, plus the willingness to assume the risk involved. Given this willingness and the proper timing, much money can be -as has been made on the short side of the market.

Timing the Short Sale
Short sales obviously should be made chiefly in bear markets. The question then is, in what phase of the bear market?

It will be recalled from a previous lesson that bear markets occur in several well-defined phases - (1) the initial sharp break, (2) a period of heavy liquidation, (3) a series of intermediate rallies, followed by declines, (4) then a prolonged period of dullness.

It will be seen that the ideal time for short selling is (1) in the very beginning of the bear market, just before it stars to slip, (2) as it is breaking wide open on heavy liquidation, or (3) as one of the intermediate rallies starts to show signs of petering out and is starting the next decline, or "leg," of the bear market.

It will be seen that the ideal time for short selling is (1) in the very beginning of the bear market, just before it starts to slip, (2) as it is breaking wide open on heavy liquidation, or (3) as one of the intermediate rallies starts to show signs of petering out and is starting the next decline, or "leg," of the bear market.

Conversely, the worst time to sell the market short would be (1) when selling has run its course, such as after the first big break has spent itself, and (2) in the last phases of the bear market, when a decline would be of very small proportions. Of course, it goes without saying that one would not sell short in a bull market, or at least until a bull market shows unmistakable signs of exhausting itself. About the only exception to this rule is if some individual stock is believed to be overvalued and will decline even though the market as a whole is moving upward.

What we have said above about the most dangerous time to sell the market short, of course, is only plain common sense. Yet, here again, it is interesting to note that the general public, or that part of the public that goes in for short sales, is generally as wrong in its bearishness as it is in its bullishness. Just as the general public tends to buy most heavily just before the bull market collapses, they frequently start selling short just before the bear market ends!

Therefore, one should watch for signs of a rising "short interest." These figures are usually published after the 15th of each month. They report the amount of short position in each major stock and the total amount of all short positions outstanding.

Thus an increasing volume of short positions suggests two things, especially if the market has already had a substantial decline:

(1)Under such circumstances, it might be unwise to initiate any large short
operations, because eventually all the "shorts" must buy back stock to cover their sales, and you might be embarrassed to find all the other shorts competing with you for stocks.

(2)Usually, a sharp rise in the short position precedes a "secondary rally." If other
signs point to a possible secondary rally, it might be better to trade on the long side of the market at that point than on the short side.

A Safe Method of Short Selling - "Selling Against the Box"
As already indicated, short selling has attractive profit possibilities, but it is a tricky maneuver, especially for the inexperienced. And even with seasoned professionals, it requires precise timing and constant attention.

However, there is a method of short selling that is virtually riskless, and that is being practiced on an increasing scale. This is the practice of "selling against the box."

In this type of transaction, the investor is in the unique position of being both "long" and "short" of the same stock at the same time.

This particular type of short selling is especially favored by investors who are holding stock on a long-term basis and who may not wish to switch into and out of their holdings, even when the price of these stocks shows wide variations. But, in order to offset paper losses on their stock holdings in declining markets, such investors sometimes arrange to sell short the very stock they are carrying in their ?long-term? investment portfolio. Such short sales are, of course, subject to the Securities and Exchange Commission price restriction rule as noted on page 5.

For example, one may be carrying International Business Machines as a long-term investment. Despite the high intrinsic quality of this stock, it nevertheless shows wide price swings. Along toward the peak of a bull market, it may become apparent that IBM is selling at a rather high price and that it might be vulnerable in the event of a general market decline. To be protected against such a contingency, the stock is sold short, while simultaneously keeping the IBM shares intact in the strong box. (Hence the term, "selling against the box.")

The mechanics of this operation are simple; they are much the same as in any other short-selling operation. The short seller borrows the stock, orders his broker to sell it short, and delivers the borrowed stock to the buyer. But the one big difference is that he also holds his original stock, and could use this to cover his position if necessary.

Of course, he would do this only if the market rose, instead of declining, as expected. In that case, whatever he loses through the rise in price on his short sale is offset by the gain on his long position. He has gained nothing, but has lost nothing either, except the transactions costs of selling short and then covering.

On the other hand, if the stock declines, he makes a profit on his short sale, offsetting the paper loss on his long holdings, and still maintains his original holdings intact.

If he hadn't effected this short sale, he would have sustained a paper loss on his original investment which might have taken years to make up!

The example cited above is based on a situation in which the investor seeks to hold onto his stock position (except if the market rises above his short sale price) but at the same time be afforded protection against price erosion. Another advantageous use of "selling the box" is a situation wherein the investor wants to sell his stock at current price levels to realize a capital gain, but for tax reasons also seeks to avoid any additional income during the current taxable year. By "selling against the box" the investor can, for tax purposes, defer recognition of his gain to the year in which the short sale is covered by delivery of his stock. Thus, not only has the investor been able to "lock in" his profit, but also defer it to a more advantageous tax year.

Meeting Objections to Short Selling
One frequently hears questions on the various phases of short selling, and the interesting thing is that the same questions keep recurring down through the years. And besides questions, there are many objections and criticisms of the practice on supposedly moral or ethical grounds. Needless to say, few - if any - of these objections have any valid basis and, in nearly every case, they arise from an inadequate understanding of this type of stock market operation.

We have heard many able expositions on, and defenses of, short selling, but probably one of the best is the view expressed by Richard Schabacker many years ago. What he said is as pertinent now as it was then:

Selling High and Buying Low
"How can a person sell something that he does not own" Is it right to sell something that you don't own ? The answer to such questions must be found in the fundamental economics of any type of business or trading, and in examples of short selling with which we are quite familiar and sympathetic in every-day life, but which we do not consider in their rightful light of a short sale. And such questions as those quoted above would not be asked if the questioner were familiar with the fundamental nature of the economic principle involved in selling short.

Use of Credit in Short Selling
Credit has just as important a place in selling stock short as in buying it long. More in fact, since credit need not be used in buying stock long, if the buyer chooses to pay for the entire purchase price of his stock and own it "outright." But credit must always be involved in the short sale because it involves borrowing something which one does not presently have. Otherwise it would not be a short sale. If a man sells a stock short, he sells it first - without actually having the stock - and he must therefore borrow it from someone who has it and is willing to lend it to him.

This answers the question as to how a man can sell something he does not already have. He does it by promising to deliver the thing he has sold at some future date. And this promise is the factor involving the use of credit. Credit is merely the process of acquiring something now for which promise is given to pay in the future the other article involved in the transaction, and whose delivery, except for the use of credit, would be demanded by the seller at the time the transaction was made.

However, it must not be assumed that the short seller's stock broker accepts his client's promise without additional backing. This customer must put up margin with the broker to protect his short-sale commitment. At present, the margin is 50%. The customer can either put that up in cash, or in securities on which he can borrow 50% of their market value. Thus, if the customer sells short stocks worth $10,000, he must deposit $5,000 in cash with the broker, or listed stocks worth $10,000 on which he can borrow $5,000. (Note: 50% margin prevailed at the time this was written by Mr. Schabacker. Margin requirement change periodically. The Forbes Chart of Business and Security Trends, supplied in the kit, shows a history of margin changes from its inception to date.)

Use of Credit Always Necessary
The man who bought his house and lot on credit acquired his property by giving his promise to pay the other article involved in the transaction (money) at some later date. The man who bought his radio on the installment plan made a transaction by which he acquired one value in the transaction (the radio) by giving his promise to pay the other value involved in the transaction (money) at a later date.

The chief fallacy involved in condemning the practice of selling stock short lies in the too-common belief that a sale is a sale and not a mutual transaction, involving both a buyer and a seller, and, conversely, the fallacy that a purchases is only a purchases, and not a mutual transaction, involving both a seller and a buyer. Cash is just as much a value as is a radio, or a home. When our friend bought his house and lot, he was merely one party to the transaction in which two parties were involved. Furthermore, his house and lot were merely one side of the transaction in which two sides were involved. When he bought his house and lot he made a trade, not a purchase. He traded a certain amount of money for his house and lot. He traded one value for another.

The answer to the "moral" question in short selling is dependent merely upon a true understanding what the transaction consists of and how the use of credit enters into it. It is all question of what one is short.

The farmer who receives his cash now for the crop he expects to deliver at a later date is "short" his crops to be delivered. The newspaper which collects the price of its subscription in advance is "short" the copies of the paper which it promises to deliver at later dates throughout the year. The club which collects dues from its members in advance is "short" the comforts and convenience of the club which the organization promises to deliver at a future date. The landlord who collects his rent monthly in advance is "short" the use of his apartment which he promises to deliver during the following month.

In similar manner, if you sell 100 shares of American Can short, you receive the purchase price for that stock by promising to deliver the stock at a later date. Even our staid and conservative and morally upright Government is short the transportation of a letter when it sells a postage stamp. And the Treasury Department of the United States is selling short fundamentally, when it collects cash from its investors and delivers to them merely a piece of paper with promise to pay at some future date the amount of money which it receives at the sale of its bond, or certificates of indebtedness.

Both from a moral and from an economic standpoint, all such transactions involve the receipt of one value in the transaction now through promise to make deferred delivery at a later date of the other value involved in the transaction. And in all these cases the transactions are negotiated through the use of credit, through the faith on the part of one party to the transaction, in the ability and willingness of the other party to make good his promise to deliver at a later date. And, from the standpoint of moral values in economic transactions, it is difficult to see how selling stock short on the New York Stock Exchange is any more dangerous or any more deserving of condemnation than any of the other common and approved transactions which we have cited above.

Short selling of stocks has its dangers from a practical standpoint due to the nature of the element traded in, and due also to the human element and the psychological justification. From a practical standpoint, short selling in the stock market is justified only on special occasions and only for the operator who has had experience and long study in the market.

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