Beware the Ides of May

The stock market rally since early March has been impressive, but only on the surface. Since the market bottom on March 9, stocks as measured by the S&P 500 have rallied nearly +30% through the end of April. This has understandably raised hopes that the worst is now behind us and a sustained long-term rally is fully taking hold. Unfortunately, a closer look suggests that investors are likely to grapple with more downside in the months ahead before the current bear market is finally over.

The length and magnitude of the recent stock advance is typical of a bear market rally. When the stock market navigates through a major bear phase such as today, it does not move lower in a straight line. Instead, the broader down trend is characterized by violent corrections followed by sharp rallies. For example, stocks have endured several episodes over the last century - 1929-32, 1937-42, 1973-74, 2000-02 and today - where the market has declined by –40% or more from its peak. During these past “great bear market” episodes, the stock market managed to post 17 double-digit bear market rallies that lasted an average of 44 trading days. Gains during these bear rallies averaged +22% and reached as high as +48%. But after each of these 17 past instances, the stock market rolled back over to set new lows. So while Friday’s rally is promising, the +29% rebound over 36 trading days is still well within the norms of a typical bear market rally. Putting the current rally in a different perspective - despite its recent strength off of its March 9 lows, the stock market is only back to where it was on January 28. So while things have certainly improved from recent depths, stocks are still far from out of the woods just yet.

Current fundamentals also do not suggest a sustained rally is underway. A variety of economic and market indicators have merited monitoring to suggest that liquidity is starting to increasingly flow through the veins of investment markets to support a stock rally. Yet many of these leading indicators either remain locked up or are still sending warning signals. This includes short-term Treasury yields that remain virtually at zero, still heightened currency volatility, corporate bond spreads that remain elevated, a VIX that is well above 30 and LIBOR spreads that while improved are still disjointed from normal levels. Beyond these indicators, the broader economic outlook remains cloudy at best with no clear sign yet emerging as to when the economy is set to trough and enter a recovery phase. Although it may not be necessary for all of these signals to read green before the market exits its bear phase and enters a sustained recovery, at the least they provide reasons to continue to proceed with caution in the current environment.

A retest of March 9 lows is a minimum requirement to declare a bottom in stocks. Even if it turns out that March 9 is the final bottom of the current bear market cycle, the rally from this bottom is unlikely to be a straight line higher. Examining each of the “great bear markets” over the last century (1929-32, 1937-42, 1973-74 and 2000-02), the stock market rolled back over and moved lower over a period averaging nearly two months to retest its final bottom before exiting each bear phase and beginning a sustained rally higher. Unless the current bear market breaks with historical precedence, the market will likely retest its March 9 low of 667 on the S&P 500 during the summer before a final bottom in the market is set. As a result, if during a retest stocks can hold in the 690 to 740 range on the S&P 500 and rally decisively higher, this would be a positive signal suggesting that a bottom in the current bear market may have been set. However, if the market rolls back over in the coming weeks and breaks decisively below its March 9 bottom, it will be likely that another retest of fresh new lows set during the summer would be required once again during the fall.

Beware the Ides of May. So when might we expect the market to roll over and retest new lows? History suggests that a new stock down leg may be set to begin in the coming weeks. In nearly every calendar year during past “great bear markets”, stocks traded sharply lower over the period from mid May to mid July, posting an average decline of –17% and a maximum decline of –30%. The only exceptions to this rule occurred during the 1937-42 bear market in 1938 and 1939, but stocks had just completed declines in excess of –20% in the weeks leading up to May during these two years.

Conclusion: While the recent stock market rally has raised optimism that the bear market may be behind us, numerous factors suggest that the market may need to retest March 9 lows before a final bottom can be declared. Thus, it is important to continue to proceed with caution when managing stock portfolios in the coming months. This is particularly true since the period from mid May to mid July has traditionally been a difficult stretch for stocks during major bear markets.

Disclosure: No positions.

Comments

[Mad Hedge F...:]

It’s time to sit down and smell the roses. Go climb that Alpine peak you’ve always wanted to attempt, finish off that basement, or take the misses down to Cabo. Maybe your nine iron needs some work. Whatever. There are no decent risk/reward trades in the market right now. All of my long recommendations, like emerging markets, commodities, crude, and junk bonds, are through the roof. My shorts have cratered, with the 30 year Treasury bond futures down a whopping 20 points, from 142 to 122. All of my longs are way overbought, and my shorts are oversold. I can’t in good conscience ask traders to just sit on big unrealized profits. Never slap a double in the face, especially in this environment. Nobody ever got fired for taking a profit. Always leave the last ten percent for the next guy. There is no law that says you have to trade every day of the year. Better to reestablish at better prices, like in August. If you strapped on any of these trades, the first four months of 2009 gave you a great year. If you didn’t, don’t break your back playing catch up. It’s not worth it. As for me? I’m going down to Vegas to shop for condos at ten cents on the dollar and do some actual gambling.

May 03 09:15 AM

[Brad Castro:]

Some good points - nothing much I can find to disagree with. Although I'm not fully onboard the the DOW MUST retest the 666 lows.

But still, we're probably still quite a ways from a sustainable recovery and in bear markets, big moves over weeks and months in either direction--as you point out--is well precedented.

May 03 09:54 AM

[Alphameister:]

I'm expecting a near-term pullback and am hedged accordingly. But I continue to find countless stocks offering great reward-risk ratios for traders and investors. Those expecting to see 666 or lower on the S&P this year are destined to be very frustrated. Go back to late April and early May of 2003 and you'll find a prevailing opinion virtually identical to the bearish arguments being raised today. While I think the bottom has been seen for US markets, my confidence is much greater that Chinese stocks have embarked on a major bull move that faces far fewer hurdles during the next few years at least. That's where I am finding the greatest undervalued growth stocks these days.

May 03 01:29 PM

[Alphameister:]

If the market does tumble in the short run, I suspect a major reason will be Obama's petulant reaction to those sources of capital that chose the rule of law over the rule of Obama regarding Chrysler. For those of us old enough to remember the market's reaction to JFK's attack on US Steel as being unpatriotic in 1962, there ought to be a sense of unease. Obama's messianic complex and commitment to favoring labor over capital is a threat that might not yet be priced into today's US stock markets.

May 03 01:45 PM

[Market Sniper:]

For this to be more than a bear market rally (of historical proportion, no doubt!) we do need to see higher highs in place. The market has not, as yet, even surpassed the February highs. Then the January and election highs loom. Until that happens, this remains a bear market rally within a bear market.

May 03 02:40 PM

[@TexasER:]

Optimism abounds these days. Many seem to think the QE strategy is working, and that somehow we will escape the massive hangover.

Too many things still left to unwind over the next year or two. The next round of bailouts is going to spook the horses and inflation expectations will begin to rise.

May 03 05:15 PM

[Teutonic Kn...:]

"Traditionally May is the weakest month (for the stock market)...owing to seasonal and other economic factors..." Quote/Unquoted from Dr. Martin J. Pring 's book "Technical Analysis of the Stock Market".

May 03 06:22 PM

[pocono:]

only problem with this article is that its written from a bears point of view. a pessimistic one at that!. im thinking hes wrong!

just like everyone has been wrong the last 7 weeks, this is a BULL RALLY. and its about time someone delares it as one and the nottom WAS march 9th!

if u have been selective and picked some nice growth stocks they go up no matter what the market does.

all the recession stocks are doing poorly! the bears are in 4 a very long hibernation.

May 03 11:40 PM

[adan:]

nice article, thanks!

May 03 11:59 PM

[vpratt51:]

I honestly don't know. Is that not the most accurate statement? I have to admit that a year ago I was not pessimistic enough. Isn't it possible to not be optimistic enough? This game of "declaring a bottom" is important to your writing, but silly in every other way. I am indignant to the suggestion that I have not experienced "enough pain"!! Not enough blood on the street for you guys? I saw it. I felt it. Yes, there will be another drop. Yes there will be more gains. Yesterday's fools will be tomorrow's geniuses. The reverse corollary applies as often, I suppose. I'm buying good companies at good prices, and holding.

May 04 04:02 AM