Monster Bear Market Rallies: Analyzing Their Validity and Implications

After an initial surge of enthusiasm, buyers often reconsider the legitimacy of rallies. Are there significant changes in external conditions to warrant such a powerful movement? Additionally, the psychology of investment funds reinforces these surges. Many funds are either restricted from taking short positions or from holding cash beyond a certain level. Moreover, some succumb to peer pressure, joining the herd on the same bandwagon, knowing they can simply keep up.

However, it is essential to recognize that the fate of a bear market rally hinges on two paramount factors. Firstly, bear markets do not dissipate until investors wave the metaphorical white flag of capitulation. This signifies a collective detestation towards stocks, sometimes adopting a generational mindset. Secondly, a substantial policy shift is typically indicative of a reversal. In historical episodes such as 1932, 2003, and 2009, the introduction of stimulative monetary and fiscal policies marked the end of vicious bear declines.

The potential trajectory of such a process may manifest in three progressive waves. Initially, the Federal Reserve may increase interest rates to rein in rampant inflation, inadvertently leading to a recession due to tighter monetary policies. Consequently, some critical event might trigger a painful credit crunch. The Federal Reserve might step in and lower interest rates, signifying a significant policy shift. However, it is worth noting that if the Federal Reserve somehow manages to avert a recession, the bear market may retreat – but this remains a substantial “if.”

Moreover, during an upswing, investors typically seek confirmation from trading patterns to determine an inflection point. Heavy volume signifies conviction, while the breadth of the movement and the percentage of participating stocks are also important considerations. However, patience is crucial as a genuine new bull market is typically defined as a sustained 20% gain from the cycle low. Therefore, a short-lived reprieve of a few days or weeks may not hold much significance.

Reflecting on the past, market historians possess a wealth of data concerning the behavior of bear market rallies. Bull progressions tend to follow a methodical and steady path, while bear trends often exhibit more volatile and choppy movements. Notably, over the past 35 years, some of the most violent rallies occurred in 1987, 2002, 2008, and 2009 – all during severe sell-offs.

By scrutinizing the structure and factors influencing bear market rallies, market participants can gain better insights into their validity and potential implications.

Since its launch in 1971, the Nasdaq index has experienced 26 sessions where it added over 6%. Remarkably, 77% of these instances occurred during bear downturns, which is three times more frequent than across all market periods. Additionally, taking a look at the S&P numbers, we can analyze the frequency of powerful bear rallies during various periods.

From 1929-1931, there were five rallies of over 20%. Similarly, during 1937-1938, 2000-2002, and 2007-2009, there were four rallies of over 10% each. It is worth noting that many of these upturns lasted only in weeks rather than months or quarters. For example, during the tech crash, the four significant rallies lasted between two weeks and two and a half months. The decimating housing crash also witnessed four comebacks, each persisting from one to two months.

However, we must acknowledge the current economic climate. As of late 2022, the Federal Reserve was still hiking rates into an inverted yield curve, with short-term rates exceeding longer-term rates. This atypical rate relationship has the potential to slow economic activity as banks cut back on lending. Therefore, it is crucial to ask ourselves tough questions about the prevailing conditions:

– Is inflation still high?

– Is corporate capital spending slowing?

– Are profit margins shrinking or expanding?

– Are growth expectations realistic?

If you are uncertain about whether market upswings are a reliable signal for investment, it may be prudent to have a conversation with your financial adviser.