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Bear Market Rules Comments

John Gazy   |   April 04, 2008
The phase the economy is currently going through can be defined as the bear market. The bear market is a market that is declining over time. The opposite as you might know is the bull market. It�s hard to estimate all potential risks the bear can inflict on investors. The history shows that it can easily devastate investors� portfolios. However, if you feel like staying in the game, here are the rules of bear market plays.

For active day traders, the bear market practically offers the same possibilities as the bull market. As long as the market fluctuates, the day traders will be able to make profits. The only disadvantage is that sliding market moves are much more difficult to predict and mistakes cost much more than during the bear phase.

For long-term investors, whose objective is to build some wealth or secure retirement, the bear market offers great risks. However, there are some logical steps that might direct you in this blind-alley of total decline.

Rule #1. During a recession, buy stocks that decline slower than others or show signs of growing. For instance, high-yield stocks are usually less volatile than other shares (you can find such stocks on your own by analyzing companies� charts and the rate of dividends they pay). Some sectors tend to show better results in the bear phase. For example, stocks of companies from the consumer service sector, pharmaceuticals, durable household products and food companies tend to grow exactly at this time. Of course, if the decline is significant, the overall indices of the sectors might be sliding as well, but then investors should seek separate companies in those sectors. And despite the fact these companies are not growing as significantly as they could at the bull market, they are safer investments than others.

Rule #2. The bear market is time to buy, not to sell. Stocks of many perspective companies decrease in price, and now could be the right time for opening positions. It often happens that stocks get too cheap during the decline. If you know the real value of the company, you can buy worthy stocks at the moment when they are undervalued and thus feel more comfortable about the volatile market in the bear phase.

Undervalued stocks can be screened using the following formulas:

(1) Net current assets = current assets - current liabilities

(2) Market capitalization = share price* number of company�s shares.

If the value of net current assets (1) is higher than the size of total market capitalization of a company (2), this means the stock is in fact undervalued. At the same time, look for companies with market capitalization over $250 million and profit over $0, i.e. operating without losses. There are plenty of other �positive� criteria to screen undervalued stocks, so look at them in the Rule #3.

Rule #3. Add several fundamentals to the above rules for undervalued shares. Your investments will be even safer if you picked companies demonstrating stable increase in income for a long time, and the price of these shares is not too high compared to income and growth rates. Conservative investors may also be interested in companies that have been paying dividends for a while, but others might as well like issuers that do not give money to shareholders and keep it for their development.

A simple way to estimate a company�s financial condition is by looking at the current ratio, which is calculated as relation of current assets to current liabilities. Conservative investors would seek companies with current assets being two times larger than current liabilities. The ratio of 1.5 is safe enough to invest in a company. The general principle is as follows: the higher the ratio, the better the financial state of a company.

A company with a �good� value should also receive profits. Investors usually want the profits to grow over time, the more the better. A perspective company should at least demonstrate higher profits in current year as compared to the previous one.

Fair value of a stock means that what you pay for each $1 of profits is fairly low. Let�s say $10 per $1 in profits is low price. In other words, if the price to earning ratio (P/E) is under 10, the stock is undervalued. Price for each $1 in profits can be calculated in various ways, but the general idea is not to pay too much for the assets. The P/E ratio can be found in a company�s profile on any financial website.

And to sum up, even if you pick several companies that meet the above criteria, it�s always safer to invest in a bigger one. Make good buys on the bear market and have big profits when the bull comes.
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