Definition of a Bear Market Rally:
1. General stock market decline of 20% or more, from peak to trough. Note that there will always be false alarms such as in Apr to Aug 2010.
2. Bear market rally is a significant advance of indices 10 - 25% from trough to peak following a bear market decline that fails to break above previous peak and/or sustain over the peak for 10 or more consecutive trading days.
3. If the decline was very steep, e.g. > 25%, and a rally of 33.3% occurs and is sustained for at least 10 consecutive trading days, then it is not a bear market rally. Similarly, a 30% decline will require an advance of 42.9%.
4. After failing to capture and/or sustain the previous peak, stock indices must fall and penetrate the previous trough within a timeframe. This must occur within a time frame not to exceed 2x the amount of time that elapsed between the original peak and original trough. For e.g. the S&P500 peaked on 2 May (1371) and fell to a low on 4 Oct (1075). This took about 5 months to pan out. Hence, by Aug 2012, we should see a break below the previous low of 1075.
5. A Major Reversal is deemed to have occured (as opposed to a continuation of a bear) if both the bear market decline and the recovery that exceeds the previous peak are "confirmed" by general market movements in which the S&P500, DJI, NASDAQ, Russell 2000 and Wilshire 5,000 ALL participate fully in the criteria set out above.
How to Recognise a Bear Market Rally
Bear market rallies are like bottoms; you can only know for sure that they occured in retrospect. The challenge is to be able to identify the characteristic of a bear market rally as one that is occuring so as to not get lured into one.
The characteristics of a bear market rally are:
1. Fundamentals continue to deteriorate.
In a bear rally, the fundamental forces that led to the initial decline still exists and are deteriorating beyond the level that was seen during the trough. Stocks often rally on relatively insignificant news during a bear market rally. Despite the positive sentiment of late brought on by the ECB buying Italian bonds, the latest economic data from the largest economies shows no signs of improvement.
2. Sharp, relatively low volume advance.
Extremely sharp advances on relatively low volume, driven by purchases by short sellers, put buyers and call sellers that are aggressively executing stop-loss orders. This is indicative of investor behavior driven by emotion rather than carefully considered fundamental and technical criteria. Behavior such as desire amongst traders and investors to "not miss out" on a rally. The rally in the last month was accompanied by smaller volumes than the sudden decline seen in early Aug 2011.
3. Sentiment recovers to extreme highs prior to recovery of prices.
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.
Fundamentals
The stock market decline between May 2 and Oct 4 was premised on fears of a significant global economic slowdown or recession. 2 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 fiscal situation in the US beyond tolerable levels due to political dysfunction. Both drivers are still in play.
For the crisis in Europe a catastrophic economic and financial crisis in Europe appears more likely today than it did on Oct 4.
For the US fiscal situation, little has changed. US leaders seem just as far from reaching any sort of acceptable compromise as they were on Oct 4.
GDP and economic activity data may have been better than expected on 4 Oct. 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 2.
The threat to the US economy that caused the original decline was never endogenous. the threats were always exogenous ni the form of political inaction on the fiscal front and the crisis in Europe.
Over 30% of SUP sales came from non-US sources and roughly 50% of net earnings. It is important to note that global growth prospects have deteriorated substantially since Oct 4. 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.
Hence, a sustained recovery above previous highs is not likely. To the contrary, all these factors combined suggest a net deterioration of fundamental factors since Oct 4. Thus new lows are a strong possibility.
Character of Market Action
The advance from the lows on Oct 4 has been extremely sharp. It has been characterised by large "air pockets" and low volume. One measure of vulnerability of the advance has been the swiftness and intensity of pullbacks, as the "air pockets" left behind are filled.
A 50% retracement (1183 on S&P500) of the most recent countertrend high to the trough would offer another strong signal that the recent recovery will ultimately be categorised 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 backfiling 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.
Some analysts have stated that the sentiment indicators that track the level of equity exposure recommended by the newsletter advisors, that the massive increase in bullishness since Oct 4 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 the analysts' view.
Other indicators tell a different story. Implied volatility and other measures of risk aversion indicate a great deal of residual fear and hesitation on the part of investors. Further, 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 Oct 4 for sure. But I also think that they are still positioned much more defensively than they were on May 2. This suggests that if good news were for whatever reason forthcoming, the stock market could rally significantly - potentially beyond the May 2 highs.
I don't 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? 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 weightings on May 2 would also trigger a warning signal.
Conclusion
On balance the evidence points to a high probability that the advance since Oct 4 will be viewed in retrospect as a bear market rally. Overall, fundamental trends and fundamental risks have deteriorated significantly beyond what they were on Oct 4. Further, the very sharp and low-volume character of the recovery off the Oct 4 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.
I believe that within the next six months, the stock market will initiate a leg down that will penetrate the recent 1075 low on the S&P500 and ultimately take the index to a region between 950 and 1020.
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), DJIA 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 these, bearish investors and traders should not become overly confident regarding the prospects of a decline. Persistently high levels of risk aversion and 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.
