Let’s make one thing clear from the outset. Value added by traders and investors during a “bear market rally” is worth just as much as value added during a bull market rally.
The difference is a matter of time frames. A bear market rally is generally a prelude to a subsequent decline that penetrates the prior lows.
Bear market rallies are a dangerous phenomena because they tend to be dramatic affairs that entice investors and traders to go long equities despite a lack of validation by solid fundamental and technical criteria. The decision to buy into such a rally is usually regretted by investors and traders when the market swiftly makes a move towards new lows. After the peak of a bear market rally is reached, the decline is generally so swift that most investors are unable to exit the market at a price higher than their original entry basis.
Thus, the question: Is the rally that commenced on October 4, 2011 a bear market rally?
What Is A Bear Market Rally?
First, we should define a bear market rally. Be advised that you will not find this definition in any trading almanac. This is my own definition. However, I believe that this specification will accord with general understandings of what constitutes a bear market rally.
- A “bear market” is defined as a general stock market decline in which major stock indices decline by roughly 20% or more, from peak to trough.
- A bear market rally is a significant general stock market advance (10%-25% from trough to peak) following a bear market decline that fails to capture the previous peak and/or sustain itself over said peak for ten or more consecutive trading days.
- The requirement to recapture the previous peak is relaxed if the prior decline was particularly steep – specifically 25% or more. In this event, the criteria to disqualify the recovery as a “bear market rally” will be met if the recovery exceeds 33.3% and is sustained for ten or more consecutive trading days. (Note that recapturing a peak after a 20% decline requires an advance of 25%. Recapturing a peak after a decline of 30% would require an advance of 42.9%.) Note that an advance of 33.3% from a trough will represent a 100% retracement of a peak to trough decline of 25%.
- To complete the definition of a bear market rally, after failing to capture and/or sustain the previous peak, the stock market must fall and penetrate the previous trough within a timeframe not to exceed two times the amount of time that elapsed between the original peak and original trough.
- Disqualification as a bear market rally will be strengthened if both the bear market decline as well as the recovery that exceed the previous peak are “confirmed” by general market movements in which the S&P 500, Dow Jones Industrials, Nasdaq, Russell 2000 and Wilshire 5,000 all participate fully in the criteria set out above.
- Disqualification as a bear market rally will be strengthened if the recovery subsequent to the bear market trough is “confirmed” by parallel recoveries (meeting the same criteria) by at least three of the following five cyclical sub-indices: Dow Transports, S&P Basic Materials, S&P Consumer Cyclicals, S&P Industrials and S&P Technology.
Based on the above criteria the current stock market recovery will be considered to be a bear market rally if the S&P fails to capture and sustain 1,371 for ten or more consecutive days and the S&P 500 ultimately declines to a level below 1,075 prior to August 9th, 2012. Confirmation by the other indices indicated would solidify the case for or against characterization as a bear market rally.
How Can One Recognize a Bear Market Rally?
Bear market rallies are like bottoms; you can only know for sure that they occurred in retrospect.
Thus, the challenge is to be able to identify the characteristics of a bear market rally as one is occurring so as to not get lured into one.
There are three main characteristics of a bear market rally.
- Fundamentals continue to deteriorate. In a bear market rally, the fundamental forces that led to the initial decline are still in play and are in fact deteriorating beyond the level that was generally anticipated at the time of the trough. Stocks will often rally on relatively insignificant news during a bear market rally – news that in no way negate causes of the original decline. However, in a bear market rally, fundamental deterioration continues beneath the surface despite rising stock prices.
- Sharp, relatively low volume advance. Bear market rallies are characterized by extremely sharp advances on relatively low volume. Such advances are driven by price-indifferent purchases by short sellers, put buyers and call sellers that are aggressively executing stop-loss orders. Furthermore, in bear market rallies the sharpness of the price increases indicate price indifference on the part of long investors. This is indicative of investor behavior driven by emotion rather than carefully considered fundamental and technical criteria. Specifically, such behavior indicates a fervent desire (frequently referred to as greed) amongst traders and investors to “not miss out” on a rally.
- Sentiment recovers to extreme highs prior to recovery of prices. Stocks must typically “climb a wall of worry.” If sentiment indicators show extremely high levels of bullishness and/or extremely low levels of bearishness, this is an indication that the rally may not penetrate the prior highs. Extremely bullish sentiment suggests a high probability that reasonably foreseeable positive factors are already almost entirely discounted in the price of stocks.
Now, let us see to what extent the recovery since October 4, 2011 meets the criteria of a bear market rally.
The original stock market decline between May 2nd and October 4th was premised on fears of a significant global economic slowdown or recession. Two exogenous factors drove the decline in stock prices. The first factor was a potential economic and financial crisis in Europe. The second factor was a deterioration of the fiscal situation in the US beyond tolerable levels due to political dysfunction.
Both of these bearish drivers are still very much in play.
With respect to a crisis in Europe, for reasons outlined in detail here, a catastrophic economic and financial crisis in Europe appears more likely today than it did on October 4th.
With respect to the US fiscal situation, little has changed. US leaders seem just as far from reaching any sort of acceptable compromise as they were on October 4th.
Aside from these two factors, is everything as bad as it seemed on October 4th? No. It could be quite plausibly argued that recently released US GDP growth and economic activity data more generally (employment numbers ISM indices and etc.) have surprised on the upside relative to expectations on October 4th.
Ultimately, however, these factors do not trump the prior two points.
First, GDP and economic activity data may have been better than expected on October 4th. However, it is clear that the general trajectory of economic activity and earnings data is significantly down with respect to where expectations were at the peak on May 2nd. Indeed, consensus global GDP growth and S&P earnings estimates are considerably lower than they were on May 2nd and show very little prospect of returning to those levels any time soon. This suggests that it is unlikely that the market will surpass the May 2nd peak any time soon.
Second, the threat to the US economy that caused the original decline was never endogenous. The threats were always exogenous in the form of political inaction on the fiscal front and the crisis in Europe. Those exogenous threats have not gone away. To the contrary, they are exerting increasingly intense downward pressure on the US and global economies.
Thirdly, an exclusive focus on the improvement of US growth estimates since October 4th is erroneous. Well over 30% of S&P sales come from non-US sources and roughly 50% of net earnings. In this regard, it is important to note that global growth prospects have deteriorated substantially since October 4th. Even if the US economy manages to tread water, or even exceed current expectations in terms of growth, the severe deterioration abroad can drive down earnings expectations very substantially and serve as the fundamental basis for new equity market lows.
Finally, the original decline was partly caused by discounting of some given probability that various catastrophic risks might materialize. Specifically, these risks were related to the global economy and financial system. In this regard, the probabilities of catastrophic outcomes have only increased since October 4th.
All of this suggests that a sustained recovery above previous highs is not likely. To the contrary, all of these factors combined suggest a net deterioration of reasonably assessable fundamental prospects since October 4th. Thus, new lows are a strong possibility.
Character of Market Action
The advance from the lows on October 4th has been extremely sharp. It has been characterized by large “air pockets” and low volume.
One measure of the vulnerability of the advance has been the swiftness and intensity of pullbacks, as the “air pockets” left behind are filled.
In these two critical respects, the advance since October 4th exhibits the classic symptoms of a bear market rally.
A 50% retracement (1,183 on the S&P 500) of the most recent countertrend high to the trough would offer another strong signal that the recent recovery will ultimately be categorized as a bear market rally.
What might change my view regarding the relation between the character of market action and the probability that the current advance is merely a bear market rally?
For example, if the market did a sufficient amount of backfilling and successful testing of key technical levels, the advance would become solidified. Furthermore to the extent that the advance were to become supported by rising volume and broader-based participation, this would suggest a stronger base from which the rally could sustain itself.
Sentiment & Market Psychology
Rallies typically must climb a wall of worry. In particular, after substantial bear market declines, rallies are fueled by a reversal of pessimism and skepticism. If there is no more pessimism and skepticism to reverse, the rally will tend to peter out.
Noted market commentator Mark Hulbert is of the opinion, based on his own sentiment indicator that tracks the level of equity exposure recommended by the newsletter advisors he follows, that the massive increase in bullishness since the October 4th low has been too great and the decrease in bearishness has been too rapid for the current advance to be sustained. The widely followed bull/bear ratio in the AAII sentiment survey tends to confirm Hulbert’s view.
However, in my opinion, other indicators tell a different story. Implied volatility as well as other measures of risk aversion indicate a great deal of residual fear and hesitation on the part of investors. Furthermore, even if investor survey sentiment is bullish, this does not mean that asset allocations have had time to adjust to reflect such new-found bullishness.
Thus, despite bullish sentiment data, I believe that investors on aggregate, are positioned quite defensively. I believe that they are positioned less defensively than they were on October 4th, for sure. But I also think that they are still positioned much more defensively than they were on May 2nd. This suggests that if good news were for whatever reason forthcoming, the stock market could rally significantly – indeed potentially beyond the May 2nd highs.
In sum, I do not believe that the third characteristic of a bear market rally can be applied to the present case. To the contrary, I believe that this factor suggests that the market has significant upside potential in the short term if news flow is favorable – so much so that a test of the 1,371 is not out of the question on this basis.
What might change my view of this factor? Stubborn persistence of bullish sentiment in the midst of pullbacks would be a warning sign. Furthermore, evidence that the equity weightings of institutional investors and/or individuals had equaled or surpassed the weightings on May 2nd would also trigger a warning signal.
The preponderance of the evidence points to a high probability that the advance since October 4th will be viewed in retrospect as a bear market rally. Overall, fundamental trends and fundamental risks have deteriorated significantly beyond what they were on October 4th. Furthermore, the very sharp and low-volume character of the recovery off of the October 4th lows has been quite typical of bear market rallies. For these reasons, it is my view that investors should avoid being lured in by this recent advance. It is most likely a bear market rally.
As I have outlined in detail in previous articles, I continue to believe that within the next six months, the stock market will initiate a leg down that will penetrate the recent 1,075 low on the S&P 500 (^SPX) and ultimately take the index to a region between 950 and 1,020.
For this reason, I believe that all but the shortest-term traders should refrain from attempting to play the equity market on the long side through individual stocks or equity market proxies such as SPDR S&P 500 ETF Trust (SPY), SPDR Dow Jones Industrial Average ETF Trust (DIA) or Powershares Nasdaq-100 Index Trust (QQQ). I believe that investors with longer time horizons should raise cash and avoid purchasing or holding otherwise attractive equities such as Apple (AAPL), Microsoft (MSFT) and Pepsi (PEP).
Having said all of this, bearish investors and traders should not become overly confident regarding the prospects of a decline. Persistently high levels of risk aversion and the generally defensive positioning of investors mean that good news on any of the key fronts – i.e. Europe and/or the US fiscal situation – could fuel substantial rallies.
If investors want to know what would cause my current outlook to change – in either a bullish or bearish direction -- they can review the fundamental, technical and psychological criteria outlined in this article and my interpretation of these factors in prior articles. To the extent that any of these factors change, I will change my views accordingly.