Playing the Next Bear Market Rally

The recent slump in the market occurred rapidly and indicates oversold conditions. My preferred method of monitoring — and acting on changes in — momentum in the market is the Stock Market Momentum Indicator [SMMI], as constructed and calculated by CRB.

The last time this indicator flashed a buy signal was on August 31 of last year. I wrote about the signal at the time and gave my reasons for taking action cautiously. In short, the market was still near peak levels, a credit crunch was starting and the economy seemed to be heading towards a recession. The caution was warranted, as the signal, which closed on May 29, turned out to be the only unprofitable such signal since the indicator’s inception in 1994.

No disclaimer this time

I am much more optimistic that acting on this signal will yield profits. The difference this time around is that the market has taken a severe beating and sentiment is currently very low. The S&P 500 is far below last year’s peak and still only 4% above the low set on July 15.

My optimism is confined to the short-to-medium-term. I am viewing this strictly as a bear market rally and that is how I will play it. In forming expectations about this trade I look at typical results from previous SMMI buy signals – 7.0% gains over 112 days. Another yardstick to look at is previous bear market rally history. Of course they are not all the same, but a rule of thumb is that they retract two thirds of losses from the most recent peak. Retracting two-thirds of the drop from 1,426.63 (on May 19) to 1,214.91 (on July 15) would put the S&P 500 at 1,356.06. That is 7.4% above Tuesday’s close.

A sensible way to play this bear market rally is to take a long position now and to close it when the indicator flashes a sell signal. My intention is to do just that, as well as sell some other stocks when the rally runs out of steam. That way I will have enough dry powder to take advantage of even better buying opportunities that I expect to materialize next year.

Comments

[JTB:]

How can I monitor this indicator and how do you know when it is signaling a buy or sell? Thanks.

2008 Jul 30 02:53 PM

[Arnbjorn In...:]

You can monitor the indicator at at the bottom of this page:

www.crbtrader.com/crbi...

The methodology is explained on the following page and you can see there how to look for signals:

www.crbtrader.com/crbi...

You really just have to monitor the crbtrader website pretty closely to be aware of those signals. You can also read my blog, I write about the signals as they appear.

2008 Jul 30 03:59 PM

[ILL PA.:]

I WOULD LIKE TO KNOW WHY =MRVL= CHIP MAKER FOR AT&T AND APPLES I-PIODS.?
MRVL==STOCK KEEPS DROPPING.
IT WENT FROM $17.80 DOWN TO $13.70.
WHAT'S THE PROBLEM AT =MRVL=?
YOU WOULD THINK THAT ANY COMPANY DOING BUSINESS WITH APPLE & AT&T.
WOULD BE DOING GOOD.

2008 Jul 30 04:15 PM

[ILL PA.:]

I THINK THE FOLLOWING STOCKS WILL DO GOOD IN THE NEXT BULL MARKET.
CHK / CSCO / EMC / FCX / GE / HAL / IPI / MON / MRVL / MSFT / RIMM / T / V / WB / YUM.
THANK YOU ///

2008 Jul 30 04:18 PM

[ILL PA.:]

I THINK THE FOLLOWING STOCKS WILL DO GOOD IN THE NEXT BULL MARKET.
CHK / CSCO / EMC / FCX / GE / HAL / IPI / MON / MRVL / MSFT / RIMM / T / V / WB / YUM.
THANK YOU ///

2008 Jul 30 04:18 PM

[whidbey:]

will you short the next collapse this fall? I think it will be a gut wrenching ride, and a sharp and possibly long ride. Do you like gold, if so when?

2008 Jul 30 05:27 PM

[Arnbjorn In...:]

I will at least trim my long positions down significantly and might by some put options in anticipation of another big leg down. I've never been much into gold as an investment and am not very knowledgeable about it. You should be able to find plenty of articles on gold investment strategies on Seeking Alpha, though.

2008 Jul 31 11:52 AM

[NC180570:]

Hello Arnbjorn and thank you for a very informative posting.
You say that:-
"A sensible way to play this bear market rally is to take a long position now and to close it when the indicator flashes a sell signal. My intention is to do just that, as well as sell some other stocks when the rally runs out of steam. That way I will have enough dry powder to take advantage of even better buying opportunities that I expect to materialize next year"

Question: The "long position" you refer to, is it SPY or the Q's or what? Also, how much of your portfolio would you invest in this position?

Thanking you in advance NC180570 Ireland

2008 Jul 31 04:48 PM

[Arnbjorn In...:]

Hello NC,

I should have been clearer in my post that the indicator is a timing tool for the S&P 500, so any position in the broad market (or at least large caps) should work. If you want to know more about how the indicator is constructed, I recommend the links I posted above.

Regarding position sizes, it really depends on your circumstance, risk tolerance and such. Given that it is a rather low risk trade, I'm personally taking a fairly large position in SSO (SPY on steroids), but each investor has to figure out how much they are comfortable risking.

Thanks for reading!

2008 Jul 31 09:56 PM