Monday, May 4, 2009

Three Stages of a Bear Market Rally


Seven weeks ago the DOW fell below 7,000. Since then the DOW has soared to over 8200 and the S&P 500 has climbed about 30% in the steepest rally in more than 70 years.

The bulls are off and running.

But is it a bull run or is it a Bear Market Trap?

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.”

Your dutiful scribe believes there are just too many problems to work through and an unwillingness to accept the inevitable solutions to gamble in the current market. I have bailed just like I did last August.

But be forewarned. Despite my apprehensions, 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.

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. Here, then, are the 3 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” (what a stupid slogan) 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/E’s, growth, and forward estimates aren’t focused on very much. The prevailing “thesis” is much more important than the underlying fundamental situation.

Today that 'thesis' is that stimulus spending will be great news for infrastructure stocks. Reality tells you that fundamentally many of these companies are still very, very weak - yet their stock takes off like a rocket.

Most everyone goes on to warn this is a bear market rally and advise against buying too much of anything now.

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.

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

So where are we?

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.

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.

But if we are only in Stage 2, is there still not money to be made in timing the market?

Perhaps. But as the markets have shown, a bear market rally is not something to bet against.

An old Wall Street saying is that "a rising tide lifts all boats".

And it's so true. Just look at the current market, dear reader.

The most beaten up of those boats (think banks, homebuilders, commercial real estate, etc.) which were steadily sinking five weeks ago, have not only been rising with all the other boats, they have been rising the fastest.

This market tide is rising astonishingly quickly and all boats are being lifted.

But when those beaten up boats sink, they will sink directly to the bottom.

Beware, dear reader. Beware.



After making this post I came across an article by Bud Conrad, a regular lecturer for the American Association of Individual Investors. Mr. Conrad holds a Bachelor of Engineering degree from Yale and an MBA from Harvard. He has held positions with IBM, CDC, Amdahl, and Tandem. Currently, he serves as a local board member of the National Association of Business Economics and teaches graduate courses in investing at Golden Gate University.

He cites data from a study called “The Aftermath of Financial Crises” by Carmen M. Reinhart of University of Maryland and Kenneth S. Rogoff of Harvard University and then makes the following conclusion:

"Given that we are currently in a deflationary phase, it is easy to dismiss the case for inflation – and many do. We think that is a mistake. Even a summary tabulation of the unprecedented increases in government debt at this relatively early stage in the crisis make a compelling case for higher inflation, if for no other reason than that it shows clear intent on the part of the government to spend 'whatever it takes' to offset the deflationary forces now stalking the land.

This research paints a dismal story of years of economic stagnation to come. In my view, the trend is now firmly established for dollar debasement, a debasement that will eventually overwhelm the deflationary pressures from collapsing asset values. Therefore, don’t listen to the happy faces on CNBC spouting off, for the umpteenth time since this crisis began, that now is the time to jump back in and buy stocks. It isn’t.

Be extremely skeptical when you hear some pundit pronouncing that this piece of short-term good news or another is an 'all clear' signal. Until we start seeing a systematic improvement in the economic fundamentals – for example, an upward movement in consumer confidence – the only signal the economy will be hearing is that of a runaway train coming straight at it."



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