Three Stages of a Bear Market Rally

In April it was clear we were in an incredibly strong rally. At the Prosperity Dispatch, we pegged it as a rally you would want to ride all the way to the end. And it would last far longer than most expect.

We also knew it would be a highly emotional ride. After all, when you’re making 20% or more each month, the common mistake is to sell too early. It’s easy to do. The natural desire to sell for a quick profit is a strong one. But history has shown the biggest gains will be made by those that ride out a trend for all it’s worth.

In mid-April we took a historical look at the Three Stages of Bear Market Rallies, how they begin, how they last until the last bear finally gives in, and specific warning signs to look for to know when it’s coming to an end.
Here are three stages of bear market rallies we identified. As you’ll notice, at the end, all signs point to the current rally coming to an end sooner than later.Stage 1: “This will never turn around.”

The first stage of a bear market rally starts when we get the first signs of a turnaround. This happens when everyone thinks it will never turn around. 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.
As the “Obama rally” turned into a sucker’s rally, each passing week brought progressively worsening economic news. There was nothing to look forward to. Expectations were low and headed lower.

We hit this point in March and once the market started moving up on “not as bad as expected” news, it was clear a bear market rally had begun. And since the S&P 500 was down more than 55% from its 2007 highs, the set-up was in place for an extended, sharp, and lucrative rally.Stage 2: It’s a Bear market rally, “The easy money has been made.”

This is the stage where you’ll see most commentators admit we’re in a bear market rally. Many of them freely cite some warning about the coming rally they issued and it was to be expected. Most of them go on to warn this is a bear market rally and advise against buying now. By May 9th, two months into the rally, the S&P was up 36%. That’s a decent return for two years in a good market. In two months, it’s downright fantastic. By this time no one could deny the rally was real. Anyone, however, could quite easily make a case where the rally had gone too far, too fast and it was too late to get in.

This is also the stage where volatility plays a greater role. The markets quit bounding up day after day and there were real corrections (at least 5%) just to keep the herd on the sidelines.Stage 3 – “All clear! Don’t miss this.”This is the final stage. It’s when the bear market has been forgotten by most investors. It’s when the “panic buying” sets in as the big money fears 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 more aggressively than ever. This is an extremely profitable stage. Yet when the big money runs out of cash to buy shares, watch out, the end of a bear market rally is near. The clearest indicator we’re in the third and final stage is the stagnating upward momentum. The S&P 500 rose 36% in the first two months of the rally. It rose a respectable 13% in the next three months. It rose 6% in the last three months. The rally appears to be running out of steam. At this time, however, most investors feel more comfortable buying stocks than they have since the rally began. GDP is up, earnings are up, and corporate executives are issuing positive guidance about their near-term growth prospects (most refused to even venture a guess last year).

The “all clear” has been sounded by executives, analysts, and many others. And investors continue to put more money to work (or, from our philosophy, at risk). Last week was the 34th week in a row in which investors put more money into mutual funds than they took out. As for the aggressive, panic-style buying we expected, it has been largely masked by the rebound in share prices. For instance, a mutual fund manager who wants to buy 10 million shares of Bank of America only had to put up $40 million in March. A few weeks ago, the same stake would cost $180 million. As a result, a lot more money may be going in, but it’s having a significantly less noticeable impact.
———————————————————–It’s Never Different This Time
As this rally shows greater and greater weakness, the risk and reward situation continues to turn against going “all in” now. Also, since most of them have the wind at their backs and a renewed confidence, they’re sure they will be able to achieve the nearly impossible and get out at the top. Since it’s never different this time, we know those facts are not going to stop investors from trying either one of them. That’s why right now, the best advice we can follow is what we’ve stuck to since the beginning. Look for sectors with exceptional fundamentals, identify the best risk/reward opportunities in those sectors, develop a plan, and stick to it. Although day-to-day it never feels quite the same and emotions, left unchecked, will quickly cloud out reality, we know it’s never different this time. And there’s no reason to expect this rally to play out any different than every one that has come before it and every one that will come again.