Wednesday, February 17, 2016

Bear Market Rallies

Recent sentiment data shows investors to be more pessimistic than they have been in at least 4 years. Some sentiment data is the most extreme in 14 years. A recent post on this here.

The rub with this data is this: some of these sentiment extremes in the past came at the start of new bull markets and some only marked the start of a rally within an ongoing bear market.

Let's assume that the rally now is only a bear market rally. What might it look like.

Bear market rallies can last as short as a week or as long as 3 months. Gains are at least 7-8% and can be as much as 20% or more.

In real time, distinguishing a bear market rally from the start of a new bull market can be tricky. It's not unusual for the 50-dma to turn around and begin rising. After a 3 month rally, the bear market decline that preceded it can feel like a long time ago, making investors once again optimistic and bullish.

Let's look at the 2008-09 bear market first.
There were seven bear market rallies during a period of just 14 months, and three of these lasted 6-8 weeks. 
That means there was a rally about every other month. 
All except one made it back to the 50-dma (green line). 
Gains were a minimum of 7-8% and two gained 20% or more. 
Each of these rallies had a hard time staying overbought. These rallies generally started to fail as soon as RSI(5) exceeded 70% (top panel). The one exception was the March-May 2008 rally, which was strong enough to turn the 50-dma upwards. That gain was 12%. 

The 2000-02 bear market is shown below.
There were seven bear market rallies during a period of 24 months. 
All of them lasted at least a month and two lasted 3 months. 
There was usually a rally every other month, although two rallies were 4 months apart. 
Each one made it back to the 50-dma (green line), which started to rise on four different occasions. 
Gains were a minimum of 8-9% and four were 20% or more.

A small, 8% bear market rally that started from Thursday's close of $183 on SPY would make it to $197.5. A rally to the 50-dma would take SPY to about $195-196, assuming it lasted only a week or so. $196.5 is also equivalent to a 50% retrace from the November high.

A 9% rally would make it to $200, equivalent to a 62% retracement.

$197.5 to $200 therefore seem like reasonable upside targets for a small bear market rally now. Especially early into a bear market, no more than a small rally like this might be expected. Those levels are highlighted below.

Above $200, and SPY will be back inside of the trading range that prevailed for the better part of a year (yellow shading). At that point, a rally back to the December and November highs will back on the table. We will be watching to see if RSI(5) can remain overbought (top panel). This will be a good sign. A rising 50-dma will also be a good sign, but be mindful that it has given a false sense of security during bear markets in the past.

If you find this post to be valuable, consider visiting a few of our sponsors who have offers that might be relevant to you.