bear market rallies

Bear market rallies are counter-trend movements in downtrending markets.

In one sense, they’re analogous to corrections, only occurring in bear markets rather than in uptrending ones (which is why I’m writing about them the day after my post about corrections).

There are several big differences, though.

Corrections tend to be relatively short in their duration and in the extent of their decline.  They also tend to occur frequently and irregularly in any bull market.  Their major cause, as I see it, is overenthusiastic valuation of stocks in an environment where the underlying economic fundamentals are relatively well understood.

Bear market rallies are none of these.  Here’s how/why:

Bear markets themselves are often described as playing out in three phases, in the following order:

—hope, where investors are either in denial or radically misunderstand the deteriorating economic fundamentals,

—boredom, where investors understand that economies are in recession, (correctly) believe that an upturn is not likely for a considerable period of time and become reconciled to relatively poor times, and

—despair, when investors, after waiting in vain for signs that economies are turning up,  give up all hope of ever seeing any improvement.  Their negative emotional state sometimes causes them to sell their stocks across the board and at foolishly low prices.  This sort of final selloff, if one happens, typically marks both the bottom of the market, the lowest point of recession and the beginning of recovery.

Significant bear market rallies typically happen only twice in a bear market.  They mark the transitions between phase one and two, as well as between phase two and three.  They can easily produce a 10% rise in the index and can last for a month or more.  Unlike bull market corrections, bear market rallies are based on a mistaken reading of the economic fundamentals.  They fail as investors work out that the view they have of the economy is too rosy.  In so doing, they usher in the next down phase.

Market tops are notoriously difficult to detect.  So many investors incorrectly regard the first leg down in a bear market as just a big correction, which they diagnose as providing a super-good buying opportunity.  That belief is what starts the first bear market rally.

As the “boredom” phase of the bear market  stretches out, investors try to anticipate the beginning of the next bull phase.  They know that bull markets typically start when sentiment is at its lowest ebb and that the first movement upward tends to be explosive.  So they begin to argue (incorrectly, for a second time) that downside is limited and upside is significant.  They also think they can see early signs of economic recovery.  These sentiments are the tinder that sparks the second bear market rally.  It, too, fails as new economic developments throw cold water on these beliefs.