Hamilton, Ont.-based Ken Norquay is a CMT (Chartered Market Technician) and the author of the behavioural finance book Beyond the Bull which discusses the impact of your personality on your long-term investments. Here Mr. Norquay posits that we should adopt new, more useful definitions of ‘bear’ and ‘bull’ markets.

The financial world is getting more exciting. An economic storm is starting. The most dramatic lightning bolt occurred when the price of crude oil dropped below support at $90 a barrel in October.

Oil continued its precipitous drop. This collapse followed a period of stability going back to 2009. Good news for oil importers like Europe and Japan; bad news for oil exporters like Canada, Russia and the OPEC nations.

An equally surprising financial lightning bolt in 2014 has been the U.S. dollar. It’s risen for 24 of the 29 weeks ending November 30, 2014, for a 12 per cent gain versus a basket of international currencies.

Volatility heralds change

Previously, I observed both of these dramatic increases in volatility. And through November, the drama continued. I noted then that a change from low to high volatility often heralds a change in the long-term trend of the stock market. I urged readers to review their long-term financial plans and reduce the risk level in their portfolios—to shift their thinking from long-term to short-term gains.

Most important of all, it’s time to defend against the increasing probability of another 50 per cent drop in the stock market, as occurred in 2001-2003 and again in 2008-2009.

First though, a quick review of some basics on how stock markets and the economy are related and where we are now.

As every first year economics student learns, the stock market is a lead indicator of the economy. In the past five years, both the stock market and the economy have been in up trends. Expect the stock market to peak before the economy, as it is a lead indicator.

At the market bottom in spring 2009, the stock market reversed, moving from a downward trajectory to an upward one that March. The economy reversed from a recession to a recovery six months later, in September 2009.

Rising markets feed greed

Looking ahead, we should expect reasonable economic news from the United States for some months into the future, as the American stock market has not yet peaked. Our defensive portfolio protection plan must be implemented during this time of optimism and good economic news.

This is important. Human beings have this psychological quirk that makes it so difficult to become defensive at stock market tops: there’s too much favourable economic news. The market has been going up for so long now, we have become unrealistic about how easy it is to make money in it.

Question: What’s a less polite word meaning “unrealistic about how easy it is to make money in the stock market?”

Answer: “Greed.”

In my stock market book Beyond the Bull. I discuss in some detail the interplay of fear and greed. These two emotions cause most of our losses in the stock market.

We get greedy at market tops and fearful at market bottoms. And, as a result, we buy at market tops and sell at market bottoms. In order to succeed in the stock market, we need to do the exact opposite.

Stick to a good investment plan

How can we bring ourselves to sell near tops and buy near bottoms? By changing what we feel. We need to feel worried (mildly fearful) at tops and confident (mildly greedy) at bottoms.

We need a good investment plan that involves both buying AND selling. Our plan has to have a systematic pre-conceived way of looking at risk in the economic world and reacting to changes in that risk. When risk is low, we add to our portfolios of stocks by buying and, when risk is high, we reduce our exposure to the stock market by selling. Note that conventional salesman’s wisdom calls for a different approach: Buy whenever you have money and do not sell.

The level of risk in today’s stock market is high. Start thinking more cautiously. Learn to think differently. For now, stop focusing on long-term investments and start thinking like traders about short-term possibilities. After 68 months of bull market, the long term is over.

New definitions for ‘bull’ and ‘bear’ markets

Here is a suggestion for changing the way we think about the stock market: Let’s change the basic definitions.

What’s a bull market? What’s an uptrend in the stock market? Previous training has taught us that an uptrend or bull market is a long period in which stock market indices go up on average. The five years and eight months from March 2009 to now is a good example of a bull market.

A bear market is defined as a shorter period when stock market indices go down on average. For the U.S. market, November 2007 to March 2009 is a good example of a bear market; or June 2008 to March 2009 for the Canadian stock market. Let’s look at these time periods from a different perspective.

Our new definition of a bull market will be “a period when investor attitude turns from fear to greed.” And a bear market will be “that time when investor opinions turn from greed to fear.”

Instead of measuring stock prices, we’ll measure investor emotions. Will these new definitions help us sell stocks in the times of high risk and buy in periods of low risk?

Our new definitions versus performance

When the S&P 500 composite index bottomed in March 2009, the economy was in a recession, the world’s banking system was a shambles, the U.S. auto industry was teetering on the brink of bankruptcy and the words “bail out” were everywhere. Investors were scared. Now, five years later, the S&P 500 has tripled and people are feeling very confident. Fear has vanished; it has turned into greed.

Prior to that, in November 2007, U.S. investors were celebrating the fact that the stock market had exceeded its year 2000 highs, housing starts were healthy and their economy was strong. It was a time of confidence in both President George W. Bush and U.S. Federal Reserve chairman Allan Greenspan. After that, in 16 short months, all that optimism turned to pessimism as the S&P 500 lost more than half its value. Greed had turned to fear.

The human factor: Even our new definitions have limits

The problem with using fear and greed as stock market indicators is that institutional money managers can always become even greedier and push the markets up even further. In downtrends, they can become even more fearful and push the market lower.

How far can human emotions be pushed? No matter how sophisticated our methods, good investing still requires judgment, skepticism and caution.

Good judgment and caution call for protecting your portfolio by following a well-thought-out action plan: Buy into the stock market in periods of low risk; sell in periods of high risk.

To do this successfully, we need to be able to recognize risk.  Paying close attention to the interplay of greed and fear can help us make those judgments.

Applying these lessons to the market

As 2015 begins, what investments are drawing fear and pessimism? What investments are in the low risk part of their cycles?

Speculators should consider the fear-infested gold mining stocks as short-term trading instruments. A word of caution, though: Gold mining stocks are volatile; be sure you have a well-thought-out trading plan in place before you buy.

If speculation is new for you, keep your trades small. The shares of Kinross Gold Corp. (TSX-K) and Yamana Gold Inc. (TSX-YRI) could be worthwhile trading instruments.

At the other end of the risk spectrum we find the Canadian financial stocks: the institutional investor’s darlings right now. The iShares S&P/TSX Capped Index ETF (TSX-XFN) is an exchange-traded fund (or “ETF”) representing Canada’s largest financial stocks. It’s up over 250 per cent since the March 2009 lows.

But hold on a moment. Didn’t Royal Bank of Canada (TSX-RY) and Bank of Nova Scotia (TSX-BNS) announce layoffs recently? Is there something negative beginning here?

Isn’t it interesting that Canada’s highest quality blue chip stocks (the banks) are in the high-risk part of their cycle, and the speculative gold mining stocks are in the low-risk part of their cycle? Be careful!

The price of oil is now in a steep decline. Oil stocks are weak. Pessimism and fear are growing in the oil patch.

Keep your eye on energy stocks and remember our new definition of a bear market: The time during which investors turn from optimism (about oil prices) to pessimism; from greed to fear.

The last five years of high oil prices have given rise to huge Canadian investments in Alberta’s oil sands and huge U.S. investments in shale oil.

Low oil prices will turn these operations into money losers. The scaling back of these mega-projects will accompany the bottom of the new bear market in oil prices. The ultimate low in the energy sector lies in the future.

The MoneyLetter, MPL Communications Inc.

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