Bear markets have important rules

The bears are trying to take control. The Russell 2000, a basket of smaller domestic companies, entered a bear market on Monday and while the major U.S. equity indexes have yet to hit that 20 percent bear market threshold, approximately 70 percent of the stocks in our universe have, as have many sectors and countries.

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We are interpreters of the market, price first, then volume and then sentiment. We have done exhaustive studies going back 100+ years of market action. This involved many hours of study of both bull and bear markets. How do they top? How do they bottom? How do bull market rallies pull back? How do bear market rallies bounce? How do the masses react? From these studies, we have found characteristics that have shown up time and time again leading to our own set of rules based on these characteristics. In fact, this bearish action is playing out in almost classic fashion. Here’s what you need to know, in no particular order:

In bull markets, surprises happen to the upside. In bear markets, surprises happen to the downside. Johnson & Johnson has lost $40 billion of market cap, at least, on news related to allegations that the company was aware that its talc powder allegedly contained asbestos. A report the company’s CEO Alex Gorsky shot down on Monday in a video message. But do you think it would have lost that much in a bull market? In bull markets, good news is great news and bad news is even good news. In bear markets, good news is bad news and bad news is horrid news. In bull markets, overbought becomes more overbought. In bear markets, oversold becomes more oversold. In bear markets, rallies are sharp, quick and they suck you in with a feel good vibe and then screw you soon after. (We coined those words) We just had two very sharp and quick rallies up into resistance before failing miserably.

In bull markets, margin expands as greed takes over. In bear markets, margin contracts as fear takes over.. Remember, margin (leverage) is a bull market's best friend, but biggest enemy in bear markets as leverage must come off first before the real selling starts. Margin debt is now contracting markedly down to a one year low.

In bear markets, the biggest losers will be the names that had the strongest runs during the bull market. Market players will not believe how low some of the most popular names drop. This occurs because their popularity makes them over-valued, over-loved and over-leveraged at the most inopportune time. Take a look at the popular FAANG stocks for some reference.

In bear markets, the average stock will lead the indices down. You are seeing it in plain sight right now...and it is happening again over the past few days.

In bear markets, defensive areas will hold up best, at least for a while (Utilities, REITs, Consumer Staples and the like) Guess what is being hit the least now? This is because the big money is selling risk and has to park the money somewhere. They always choose the biggest, most liquid, boring low beta names. The only new yearly highs have come from these areas recently.

On that note, in bear markets, the Dow holds up best because it is laden with the biggest, most liquid, boring low beta names. Notice how Pfizer and Merck are trading near yearly highs. Also, notice how even big technology names like Cisco and Microsoft have held up well. It is sell the higher beta tech to park the money in the bigger, lower beta tech.

In bear markets, the curtains come down on bubbles, on manias, on biotechs with no revenue, on money losing companies and on ridiculously priced IPOs (SNAP comes to mind) as bull markets are friendly to excessive speculation. Bear markets will crush excessive speculation. You are seeing it in real time in the crypto coins with leader Bitcoin off over 80 percent since hitting an all-time high this time last year. Some are even going bye-bye and now we are seeing it in the weed stocks...even though the defenders continue to swear by both. Bear markets make valuations matter.

Towards the end of bull markets, no one believes a bear market is possible, especially after not having a real bear market since ‘09 because of the moronic, imbecilic dolts at the central banks around the globe who refused to let real price be discovered. (Do you think we like central banks?) As the bear winds its way, more and more pundits convert and more and more people come to the recognition. Price does move the brain matter. Of course, this will not be called a bear market right now because frankly, the two most popular indices are only in what they call "correction" territory but the average stock knows better. If this is not a bear market, we hate to see what a bear market looks like.

We do not have every answer. We just watch price as price is everything. We have spent countless hours studying the greats like O’Neill, Weinstein, Darvas and others which helped us come up with these rules. We never know how long bull markets or bear markets last but we believe we know what characteristics show up during both. We believe there is a good road map and have proved it again. As we have always told you, we just want to get the big picture correct.

Gary Kaltbaum is a registered investment advisor with more than 30 years of experience in the markets. He is owner and president of Kaltbaum Capital Management, a financial investment advisory firm headquartered in Orlando, Florida. He is a Fox News Channel Business Contributor regularly appearing on Fox News Channel and the Fox Business Network. Gary is the author of the book “The Investors Edge” and is also the host of a nationally syndicated radio show with the same title “Investors Edge” which is broadcast on numerous stations across the U.S.