How to Profit from a Flat to Down Market 

Why would we be interested in profiting in a flat to down market? The DJIA has risen 3,500 points since March of 2003, and that's a 43% gain. Aren't bull markets the norm for America? Aren't we in a bull market now? And won't this bull market continue?

You see, we're not in a bull market. Instead, we're 7 years into a secular bear market. How do we know that? Because the DJIA is lower today than it was in January of 2000. You can verify this at BigCharts.com. Just click on historical quotes and plug in DJIA for January 14, 2000. You'll see 11,908, the high over the past 7 years.

Now, if our secular bear market continues, and history suggests it will, the market action going forward will be flat to down, and possibly even severely down. But before I show you why, let's be clear with our terms. A secular market is one in which the primary trend lasts for 10, 15, or 20 years.

Secular markets are long-term markets. And, typically, a secular bull market follows a secular bear market, or vice versa. The main characteristic of a secular bull market is an uptrend that sets many new highs. The main characteristic of a secular bear market is volatility--lots of price swings but no new highs. Or if it does set a new high, it's just slightly higher and doesn't last (this happened twice during the 1966 to 1982 secular bear). Basically, a secular bear market ends at the same price it started, and of course a new bull market brings it to an end.

Look at this 100-year chart of the DJIA, which shows the secular bull markets in green and the secular bear markets in red. You can see we've had just 3 secular bull markets over the past century, one in the 1920s, one from 1954 to 1966, and one from 1982 to 2000. The average secular bull market lasted just under 13 years. And just 38 of the 100 years were bullish.

Next, look at the secular bear markets, one at the very beginning of the 20th century, one from 1929 to 1954, another from 1966 to 1982, and our current one that started in 2000 but has yet to end. The average secular bear market (not counting the current one) lasted about 19 years. Thus, if history is any guide, we can expect our current bear to last another 10 years or so.

It's also interesting to see that 62 of the past 100 years were bearish. This may come as a surprise, since so many of us cut our teeth on the secular bull market of 1982 to 2000 and think of those years as the norm. But the American stock market has actually been more bearish than bullish.

Okay, but if we are indeed in a bear market today, why have we seen rising prices over the past 3 years? Simple. Within a secular bull market, there are shorter-term declines called cyclical bear markets. And within a secular bear market, there are shorter-term advances called cyclical bull markets. Cyclical markets typically last 1 to 3 years, and since March of 2003 we've been in a cyclical bull market within the larger secular bear trend.

Now, here's what you need to know: Since we're at the upper end of the secular bear trading range (as of this writing the DJIA is near 11,500), and also since we're at the outer reaches of the average cyclical duration (3.5 years), it's highly likely the next significant move will be down.

Let's look at the last secular bear market in its entirety, to see if it can give us an idea of what to expect in the months and years ahead. The chart below shows the DJIA from 1966 to 1982.

Two things. First, note that this secular bear market began and ended in the same place, at about 995 on the Dow. That's 17 years of no progress. Second, take a look at the black line overlaid on the beginning of this chart — that's the DJIA for the past 7 years, from January of 2000 to October of 2006. Can you see the similarity in the patterns? And can you imagine what might happen next? The Dow could climb to 12,000 or a little higher, then fall off a cliff.

The reason is that, in a secular bear market, prices bounce up and down within the trading range but don't set new highs (or at least not significant new highs). Again, we're at the top of the trading range, and we're over-extended on the recent cyclical bull. That gives us two possibilities. One is the market could rise in the weeks ahead before reversing. And the other is it could just start moving down from here.

But what if I'm wrong? And how can we know if I am? Easy. If the Dow goes convincingly over 12,000 and stays there for a few months (as opposed to just peaking over 12,000 for a short time before reversing), we're in a new bull market. That, I suppose, is a third possibility, but history is against it.

Now, I think you'll agree it's a good idea to know what kind of market we're in before deciding on an investment strategy. It seems obvious we are NOT in a secular bull market, but rather a secular bear market. And it also appears that we're at the very end of the recent cyclical bull market within this bear market. So using a bull market strategy that counts on higher prices would be highly risky.

Instead, we need a strategy that can take advantage of the Dow's price swings in both directions -- the norm for a secular bear market. And that's exactly what Jim Patterson designed the Dow Double Diamond plan to do.

Now, to be frank, I'd like to acknowledge that over the past year, we've experienced far less volatility than is normal for the Dow. And because of that the DDD plan did not perform as well as our 4-year and 8-year records indicate. Still, Jim and I believe the longer-term record is likely to prove more accurate in the coming months and years. Why? Because extremely low volatility in the Dow is rare. Which suggests were about to return to the kind of volatility we saw early in DDD's history, when the plan produced the extraordinary gains shown in the chart below.

The above chart shows the actual trades of the DDD plan during its first 6 months of live trading, October 28, 2004 through April of 2005. Note that the starting and ending prices are pretty close. During this time, a buy-and-hold investor going long would've made about 2%. By contrast, the DDD plan racked up a 31% gain trading the Dow's price swings in both directions. And of course, leveraged DDD investments would have produced even higher returns.

So, is trading the short-term swings in both directions the best strategy for today's market? That's a decision you'll have to make after consulting with your registered financial advisor, but consider the following...

We know that, in a secular bear market, the beginning and ending prices will be the same. We know that we are just 7 years into a secular bear market that is likely to last another 10 years. We know we're at the upper end of the bear trading range and that the cyclical bull rally we've seen over the past 3.5 years is over-extended. All of which suggests the next move will be down.

Now, add to this mix the following economic and geopolitical facts. The ongoing war on terror is projected to cost $1 trillion or more, not counting an expansion to Iran and Syria. Corporate profits are softening. Real estate prices are dropping. Energy prices, though a little lower recently, are still sky-high, and with the Iran threat could shoot right back up to $80 or even $90 a barrel.

Consider also that tens of thousands of "zero interest" and "low initial payment" mortgages are being adjusted sharply upward, adding to the fast-rising costs of living for American consumers, who account for 70% of our GDP. And with falling real estate prices, consumers can no longer use their homes as ATM machines--the very cash that kept our economy afloat over the past 5 years.

What's more, the Fed, though leaving interest rates alone at its most recent meeting, left the door wide open for future rate hikes because of a persistent threat of inflation (it's quite possible we could see stagnant growth and inflation). Finally, total consumer, corporate, and government debt has now reached a whopping 300% of GDP. And every time the debt ratio has gone that high before (or even close to it), recession and a lower stock market has followed.

You don't have to be an Einstein to see that GDP will be flat for the next couple of years, and that the next big move in this market will be down. Indeed, with the economic and geopolitical conditions today, it's difficult to envision a scenario that could lead to a new bull market any time soon. That's not the end of the world, but it does require that we adopt an effective strategy for a volatile market.

In closing, let me say that, while each of us must decide what's best for his or her situation, any investment decision should be based on facts. And I hope I have provided the facts you need to make a good decision here. Until next month, good wealth building.

Sincerely

Dick Sanders