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.