What Rule-Based Strategies Do in Bear Markets

A rule-based bear market strategy decides in advance what to do when prices fall for a long time: step aside into cash or bonds, switch to assets that tend to hold up, bet on further falls, or simply hold and wait. Each approach can soften losses in some bear markets and fail in others, usually because rules react after the fall has started and get caught by sharp rallies. In AlgolaneBots's historical backtests, the strategies with a market filter lost less than the S&P 500 in 2022, but none avoided losses entirely.

What counts as a bear market

A bear market is commonly described as a fall of 20% or more from a recent high in a broad index, lasting weeks to years. Bear markets differ a lot in character:

• Fast crashes, like early 2020, where most of the damage happens in a few weeks.
• Slow grinds, like 2022, where prices fall in steps over many months with rallies in between.
• Long, deep declines, like 2000-2002 and 2007-2009, where losses build over a year or more.

A rule that handles one type well may handle another badly. That is the central problem of bear market strategy.

The five main approaches

1. Hold through it

The simplest rule is no rule: keep holding. Buy-and-hold investors in a broad index accept falls in exchange for not having to time anything. The S&P 500 fell 55% in 2007-2009 and took 53 months to recover in AlgolaneBots's data; in 2022 it fell 24% and took 23 months.

2. Step aside to cash or short-term bonds

A market filter checks whether the broad market looks healthy, often using a trend measure such as price against a long-term average. When the filter turns negative, the strategy moves to cash or short-term bonds and waits.

Big Tech Trend works like this. Each month it decides whether the market is healthy. In a weak market it moves toward short-term bonds, gold and defensive sectors.

3. Rotate to assets that tend to hold up

Instead of sitting in cash, some strategies move to assets that have historically held up better in falls, such as longer-term bonds, gold or defensive stocks. Leveraged Growth rotates between leveraged growth funds, bond funds, volatility funds and inverse funds depending on daily signals.

4. Bet on the fall

Some strategies hold inverse funds such as SQQQ, which aims to move three times opposite to the Nasdaq 100 each day, or volatility funds such as UVXY, which tend to jump in panics. Gold Breakout can sell gold short when its rules see a breakout downward.

These tools can gain in a falling market, but they carry their own risks. Inverse and leveraged funds reset daily, so in a choppy market their value can wear away even if the index ends roughly where it started. UVXY has lost most of its value over long periods. See UVXY and volatility funds and leveraged ETF decay.

5. Buy the dip by rule

Some rules do the opposite: buy after sharp falls, expecting a rebound. Market Switch switches to leveraged funds after sharp falls. When a rebound comes, this can recover losses quickly. When the fall keeps going, it amplifies the damage.

What the backtests showed in 2022

The 2022 rate-hike bear market is a useful case because it was a slow grind with both stocks and bonds under pressure. These are results from historical backtests, computer tests on past prices. Nobody earned them, and future results will differ.

Gold Breakout, benchmarked against gold held: fell 18% against 21% for gold held, and recovered in 9 months against 11.

Every strategy lost money. Leveraged Growth fell more than the S&P 500 despite its rotation rules. The others fell less. The quick recoveries are notable, and also exactly where the caveats matter most, because rules shaped by recent years can look best in recent years:

• Steady Growth: its seven names were picked because they already did well, which flatters the test.
• Big Tech Trend: its stock list was chosen with hindsight; three stocks made 81% of the profit.
• Market Switch: nearly half of its tested profit came from UVXY, and it failed outside the US.
• Leveraged Growth: its rules may be fitted to the years after 2010, and leveraged funds can lose value quickly.
• Gold Breakout: doubling trading costs cuts its yearly result roughly in half.

What the older bear markets showed

Rules built and tested on recent years face their hardest test in bear markets they were not designed around.

In the 2000-2002 dot-com crash, Big Tech Trend's backtest fell 41% against 47% for the S&P 500, and got back to its pre-crash value in 37 months against 78. Its step-aside filter did part of its job.

The leveraged strategies looked very different. Using a simplified three-fund version, because many of their funds did not exist then, Leveraged Growth fell 91% and Market Switch fell 100%, against 47% for the S&P 500, and took 115 and 259 months to recover against 78. In 2007-2009, the simplified Market Switch fell 96% against 55% and needed 73 months to recover against 53, while simplified Leveraged Growth fell 48% and recovered in 19 months. Dip-buying with leverage in a long decline is the worst combination.

Over their main backtest periods from 2011, these two strategies reported +129.1% a year (Leveraged Growth) and +71.9% a year (Market Switch), against roughly +14% to +15% a year for the S&P 500, with worst falls of 53% and 42% against 34%. The older simulations are a reminder of what those numbers leave out. More in how strategies held up in 2008, 2020 and 2022.

The traps every bear market rule faces

Reacting late

Trend filters need prices to fall before they turn negative. By definition, a step-aside rule takes some of the loss before it steps aside.

Bear market rallies

Long declines usually include sharp rallies of 10% or more. A rule that steps back in on a rally can get caught when the decline resumes, then step out again at a lower price. This back-and-forth is called whipsaw, and it can cost more than holding.

Missing the rebound

The best days in markets often come close to the worst days. A rule that steps aside may still be in cash when the recovery begins, missing the early gains.

Check frequency

A strategy that checks monthly, like Big Tech Trend, cannot react to a crash that happens in two weeks. A daily strategy reacts faster but trades more and pays more in costs. See weekly rebalancing for this trade-off.

Fitting to the last bear market

It is easy to design rules that would have dodged 2022 perfectly. That says little about the next one, which will have its own causes and shape. The overfitting post explains why.

Where gold fits in

Gold is often described as a safe haven, and the backtest data supports that only partly. In the 2007-2009 financial crisis, gold held fell 29% and in the 2020 crash it fell 12%, both far less than the S&P 500's 55% and 34%. In 2022, gold held fell 21%, close to the S&P 500's 24%. Gold tends to behave differently from stocks, but it is not immune to falls.

Gold Breakout adds another layer. Because it can sell short, a sustained fall in gold is a possible opportunity for its rules rather than only a threat. In practice its 2022 result was still a loss of 18%. Being able to trade both directions does not mean every move gets caught. See gold vs the S&P 500 in crashes for the longer comparison.

How to judge a strategy's bear market rules

1. Ask what it holds when the filter turns. Cash, bonds, gold, inverse funds and volatility funds each behave differently.
2. Check several bear markets, not one. A strategy that shines only in 2022 has told you about 2022.
3. Look at the fall and the recovery, compared with the benchmark over the same dates.
4. Check for leverage. Leverage turns a bad bear market into a potentially catastrophic one.
5. Decide what you will do. A good rule abandoned halfway through a bear market protects nothing.

Key takeaways

• Rule-based bear market strategies hold, step aside, rotate, bet on the fall, or buy the dip; each fails in some conditions.
• In historical backtests of 2022, every AlgolaneBots strategy lost money; four fell less than their benchmarks, one fell more.
• Leveraged strategies looked far worse in simulated older crashes, falling up to 100%.
• Late reactions, whipsaw and missed rebounds are the common traps.
• Judge rules across several bear markets, not the most recent one.

See how the rules react on paper

You cannot schedule a bear market, but you can watch how each strategy's rules respond to whatever the market does next. Run the five strategies on a $10,000 paper account in the free 90-day trial, with real prices and no card. Sign up here. General information only, not personal advice; see the risk notice.