In yesterday’s missive, we talked about the idea that really big, really bad bear markets just don’t happen that often. And since investors were treated to two devastating bears within a 9-year stretch, most folks are keeping their eyes wide open and preparing for the next one.

The key point is that the type of bear market that wipes out years of gains and puts financial plans of all shapes and sizes at risk by producing losses of 30, 40, and 50 percent don’t occur when most people are looking for them. No, the truly gut-wrenching bear markets have historically come out of nowhere. They take investors by surprise. And frankly, most investors don’t understand why stocks are crumbling around them until it is too late.

Ask yourself, did you know what a CMO was prior to the summer of 2008? How about a sub-prime mortgage? Did you understand the impact of Lehman’s fall on the banking system? Were you aware that heavily leveraged hedge funds were hemorrhaging wildly in the fall of 2008? And did the headlines about money market funds “breaking the buck” make you quake in your boots and/or hide under your desk?

Before the Credit Crisis and the ensuing alphabet-soup of derivative destruction, there was the Tech Bubble bear. Again, ask yourself – and be honest – were you more worried about missing the next great internet stock in 2000 than the fact that Cisco Systems (NASDAQ: CSCO) was selling at a valuation higher than 20 of the Dow 30 stocks combined? Did you heed Jim Cramer’s advice in late 1999 and begin buying “baskets” of internet stocks instead of just one at a time? And did you call your financial advisor during 1999 to demand more exposure to the stock market in general and more specifically the “hot dots” of that era? Believe it or not, a great many did.

Make no mistake about it; when the animal spirits are soaring and soccer Mom’s are trading stocks in between car pool runs, THIS is when portfolios are at risk of being wiped out. THIS is when the really hot stocks are set up to lose 70-90 percent of their value. And THIS is when it pays to know how to play defense in your portfolio.

After two brutal bear markets that, as the joke goes, turned people’s 401K’s into “201K’s” (or worse), everybody now “gets it.” Everybody NOW knows that risk management is important. Everybody is prepared for the next big bear.

So, what is Ms. Market likely to do to all those investors who are now ready with a plan for the next big, bad bear hits? If history is any guide, she will probably serve up a very long, very strong bull market, with an occasional “baby bear” mixed in just to keep everyone off balance. Remember, frustrating the masses is what Ms. Market does best!

Are Those Baby Bear Tracks?

While Ms. Market may not serve up a fat, juicy 50 percent decline any time soon, this does not mean that a “mini” or cyclical bear isn’t lurking. Lest we forget, just about everybody in the game is looking for a meaningful decline in the stock market to occur this year. As such, it is a probably a good idea for investors to be on the lookout for any signs that the bears might be awaking from a long winter’s nap.

So, let’s scout around the camp site so to speak and see if there are any paw prints to be found.

Bear Track #1: Waning Momentum – In case this is your first trip through the market cycles, it is important to recognize that the market’s internal momentum tends to peak long before the popular indices do. For example, if one plots the number of technically healthy sub-industry groups (the number above their 200-day moving averages, for example) you will find that the number tends to expand during healthy bull market trends.

However, as a bull market ages, the peaks in the number of healthy sub-industries begins to trend lower. This means that fewer and fewer groups are participating in the advance. And in the vast majority of cases, this is a very good sign that the market may be due for a meaningful decline.

The same can be said for “net demand volume.” In healthy markets, a plot of “demand volume” minus “supply volume” trends upward. But currently, this line has been moving lower for almost a year. And at some point, this will be a problem.

In short, these two indicators suggest that the market has lost its upside momentum. Unfortunately for all the card-carrying perma-bulls out there, these indicators have been in decline for some time now. And while a market can, and often does, advance “narrowly” for long periods of time, investors should take note that waning momentum is NOT a good thing.

Bear Track #2: Divergences – As they say, a picture is worth a thousand words. Or in this case, two pictures can make the point quite clear that the “troops” (the small caps) are not following the “generals” at this time.

S&P; 500 Daily

While things have been quite choppy, the S&P; remains in an uptrend and at all-time highs.

However, the Russell 2000 small cap index is clearly in a downtrend. And in short, this is a classic divergence.

iShares Russell 2000 (Small Caps) Daily

In addition, the number of stocks making new 52-week lows has been expanding lately. The key is that this just doesn’t happen in healthy market environments.

Bottom Line: Investors Need to Be Ready

While investors may not be bloodied to the degree they were in 2000 and in 2008, there are a fair number of indicators that suggest the market may be setting up for a “mini” or cyclical bear period.

The good news is that these “baby bears” tend to be brief, lasting about 3 months or so. But the bad news is that a decline greater than -15 percent could be in the cards sometime in the next year – unless, of course, the bulls can recover their lost mojo in the near term, that is.

So… the bulls are certainly free to continue to enjoy the bull party. However, note that the punch bowl is running low and the dance floor is looking a little sparse. As such, anyone interested in managing risk may want to know where the exits are at all times.

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