We're Still Not Done with This Bear Market Rally

In just six weeks the S&P 500 has climbed about 30% and the broader, small-cap focused Russell 2000 has soared 40%. It’s the steepest rally in more than 70 years. The bulls are off and running.

Despite it all, very few people believe this rally can last. And it’s because there are still so very few people getting in on this rally, odds are it won’t end very soon.

By this point, most commentators have declared this a bear market rally. The New York Times, Forbes, Bloomberg, and most every major media outlet have gotten on board.

Some of the world’s leading investors agree. In early March we looked at Steven Leuthold’s bold prediction:

These comparisons people make with the Great Depression are totally out of touch with reality, and pretty stupid…We’ve been in much worse, much more panicked and more scary situations in the U.S.

A pretty bold statement considering the Dow fell below 7,000 and was headed lower. But it’s not just Leuthold. Hedge fund manager, philanthropist, philosopher, billionaire George Soros has been quite vocal about his suspicions in the sustainability of this rally. Soros said:

It’s a bear-market rally because we have not yet turned the economy around. This isn’t a financial crisis like all the other financial crises that we have experienced in our lifetime.

If you go out more than a few months, all signs point to Soros being spot on. There are just too many problems to work through and an unwillingness to accept the inevitable solutions.

Despite it all though, it’s looking much more likely we’ll see more upside in the short-term than the start of a downturn.

Why? Because we haven’t run through all of the phases of a bear market rally.

Three Stages of a Bear Market Rally

Bear market rallies are unique events. They come when they’re least expected and can last a few days, weeks, or months. There’s no telling exactly when they will end. But if you pay attention to the life-cycle of past market movements, you can get a good idea of when this one is going to end. That’s why I closely watch the Three Stages of a Bear Market Rally:

Stage 1: “It’s all over”

The first stage of a bear market rally starts when the markets react to bad news as if it was good news. Whether it’s because bad news isn’t as good as bad as expected or it’s one of those “Green Shoots” which provide a glimmer of light perceived to be the end of the tunnel.

This happens when everyone thinks it will never turn around. It’s when many investors throw in the towel and proclaim “it’s all over.” We hit that point in early March. Since then the markets have been so beat up in such a short period of time that any bit of good news can get things rolling higher again.

Stage 2: Popular Declaration of Bear Market Rally

This is the stage where most commentators admit we’re in a bear market rally. The upswing has just been too strong and has lasted so much longer than initially anticipated by most, it’s obvious to everyone.

There are no fundamental drivers and the fundamentals matter very little in this stage. Dividend yields, P/Es, growth, and forward estimates aren’t focused on very much. The prevailing “thesis” (i.e. stimulus spending will be great news for infrastructures stocks) is much more important than the underlying fundamental situation – a.k.a. reality.

Most everyone goes on to warn this is a bear market rally and advise against buying too much of anything now. It’s also a time when we hear things like “this is a trader’s market.” Although any market should be a trader's market, given the wide number of strategies which work in bull, bear, and flat markets.

Stage 3: “All clear! Get in before it’s too late.”

This is the final stage. It’s when the bear market has been forgotten by most. Stocks move up, but the big upswings have disappeared.

This is when the very real risk of “panic buying” sets in. This is a result of the big money fearing 1) it has missed all the chances to buy low, 2) their performance will suffer, and 3) customers will take their money elsewhere.

To make up for lost time, they buy very aggressively. Many of them think short-term and want to deliver the numbers to keep pace with the competition in the money management industry. This is an extremely profitable stage for those who went against the grain and bought during the earlier stages of the rally. You’ll also see a general decline in the VIX. It currently sits at below 34 – well below its recent range of 50 to 90.

Yet when the big money runs out of cash to buy shares, watch out, the end of a bear market rally is near.

What to do Now

It looks like we’re in Stage 2. There are just too many non-believers out there right now, too much money on the sidelines yet to come back into the market, and there has been no build up of false confidence which precedes most market declines.

Just think of what happened last fall. After a sharp downturn, the markets rallied sharply after the presidential election. The so-called Obama rally was a boon for stocks which were looked at as leading benefactors of the new administration’s agenda.

Don’t get me wrong, there are still a lot of problems. Commercial real estate debt, deflation (and the debasing of currencies to prevent it), rising unemployment, and increasing and changing regulation to consistently change the rules and keep entrepreneurs and investors from tackling new opportunities, will all be a drag on the economy, at every stage of a recovery.

But, as the markets have shown, a bear market rally is not something to bet against. As a result, I recommend searching out three types of opportunities.

The first is the safe way to play a market rally, which go up with the markets, but don’t go down nearly as fast (e.g. a covered call writing ETF). The second being the sectors which have fallen out of favor during this downturn. The final being speculative stocks which have been so beaten down there’s only one way to go - up.

The old Wall Street saying, 'a rising tide lifts all boats' is true. But when the tide is rising this fast, the most beaten up boats which were steadily sinking (think banks, homebuilders, commercial real estate, etc.) have been rising the fastest.

Comments

[Carl Spackler:]

Simple success formula = short the market whenever it crosses the 50 day MA. Market has crossed the 50 day MA 4 times prior and every time if failed within a month to hold over the 50 day MA. Average stay above the 50 day MA was about 2 weeks. We are a little over 2 weeks above it now. After making a ton following this simple formula, I will not bet against it this time. In markets with strong trends (in this case downward), never go counter-trend. It is usually suicide. Counter-trend bettors can be right for only a month, but then you are left holding a bunch of $2 bank stocks. Too much downward momemtum is around - just check the monthly charts.

Apr 21 09:08 AM

[djn21:]

I agree with you Mickey, almost to a tee. The amount of cynicism (me included) likely means the market can and will continue higher short-term. Perhaps even threatening the 200 EMA for SPX. Fortunately, my Chinese micros have run hard so I don't feel the need to chase the market. I think that about the time Newsweek declares the all-clear and folks start piling in, things will turn downward again. I think government is stimulus is likely doing more harm than good, and the consumers have yet to capitulate.

Apr 21 10:30 AM

[logicalthought:]

I'm not sure that I read "sentiment" the same way. It seems to me that almost all of the "institutional talking heads" on CNBC have been pretty bullish lately; while some of them acknowledge that the market may need to "retest" the March lows, they seem to think that any retest would end in the mid-700s, and I haven't heard a single one acknowledge that there's a very good chance that the S&P low of 666 can get "significantly lower." (Don't get me wrong-- there are a few commentators who HAVE acknowledged this possibility, but very few of them are managing big money.) Thus, if the "mutual fund talking heads" (you know, the same folks who lost 40% of their clients' money last year) see only 10% or so downside from here vs "infinite" upside, I think they've probably been putting their money (what little spare cash their clients have left with them) where their mouths are. Meanwhile, I think that those folks who are truly bearish (myself included, by the way), won't buy into this rally no matter WHAT happens and, in fact, are just looking for a good place to either get short (I'll start scaling in in the lower-to-mid 900s, if the S&P gets there), or will simply stay mostly in cash until the market either gets a LOT lower or forms a multi-year base from these levels, because one of those two things is what it will take for the overall market to be a buy. (There are, of course, always a few things to buy no matter what, as not everything correlates with the overall market.)

Apr 21 10:46 AM

[dayter:]

Indeed it feels like everyone is saying retest to 770ish and bull market from then on out. I find it very rare to find people saying just a straight line up and I find the only people saying new lows are commentators, not bloggers or pundits. It feels like to me many of the forum commenter are perma-bear too. As a contrarian, i guess you might want to wait until those retest crys go away somehow or waiting for even seekingalpha turning mostly bullish (i haven't been here long enough to judge it).

I admit this isn't near the bullishness of the 950 January high or the bearishness of the 666 lows, but it is getting there. It will be interesting to see the sentiment if we get up to the lower-to-mid 900s without a huge retest

Apr 21 11:49 AM

[sr9web:]

sounds aboout right...


On Apr 21 09:08 AM Carl Spackler wrote:

> Simple success formula = short the market whenever it crosses the
> 50 day MA. Market has crossed the 50 day MA 4 times prior and every
> time if failed within a month to hold over the 50 day MA. Average
> stay above the 50 day MA was about 2 weeks. We are a little over
> 2 weeks above it now. After making a ton following this simple formula,
> I will not bet against it this time. In markets with strong trends
> (in this case downward), never go counter-trend. It is usually suicide.
> Counter-trend bettors can be right for only a month, but then you
> are left holding a bunch of $2 bank stocks. Too much downward momemtum
> is around - just check the monthly charts.

Apr 21 04:07 PM

[User 305589:]

good observations. However, IF this rally fell apart here (and the signs are already there it could) without going through phase 3 it would tell you a thing or two about how WEAK this market actually is. I agree with logicalthought and from my talks to fund managers it seems to become increasingly a consensus that a retest of the lows will either not occur (because of huge piles of money waiting eagerly to join the rally) or they may occur but will be successful. I have made just one guy among them who expects a drop through the March lows.

My take from this (for the S&P 500): we will see a shallow retest of the 750-800 region followed by a surge upward towards 920-980 in summer and a beginning drop by July. Then, when everybody expects the economic recovery to set in the data are likely to disappoint as this recovery will be much weaker than expected and give rise to fears what will happen when the govt. stimulus will be gone. Then it will be all downhill towards the March lows and on to 450-500. this will be when the ultimate selling panic sets in and when the real bottom will form -both from a sentiment and a valuation point of view. I believe that the highs of the current bear market rally (likely in the 900-1000 region) will not be seen again for years to come.

Apr 22 04:13 AM

[Mistrofan:]

My model shows me that we are still 6-7 weeks away from another intermediary low (probably higher than de Mar 6). So, no rush for the time being. Patience.

Apr 22 08:58 AM

[Old Trader:]

I wonder what bit of news will precipitate a break.....for example, I heard, late this afternoon, that GM will be shutting down plants for 9 weeks this summer, instead of the traditional 2 week model changeover shut down. I'm thinking that a GM bankruptcy has been "baked into the cake", at this, but that 9 week shutdown is going to have a serious effect, not only for the GM employees, but for their suppliers....

Apr 22 09:42 PM

[Subhankar:]

Those investors who follow global markets may have noticed that some indices are already above their 200 day EMA or hovering near it - while the Dow and the European indices are well below. Bovespa (Brazil), Kospi (Korea), Shanghai (China), TSEC (Taiwan), Sensex (India). Guess where the global economic recovery will happen first. The B(R)IC countries.

Apr 24 06:07 AM

[Paul_L:]

I was interested in what stage the market is in and author's insight after another big run up today. It sounded like and feels like everyone is thinking of going non stop higher, stress tests no issue, etc. It is a bull market now?

May 04 06:52 PM