How To Tell The Difference Between A Bear Market Rally And A Real Bear Market Bottom

This lesson is a little bit tougher to write because of the many variables involved. I decided to narrow it down to a few very important signals. Studying past bear markets and their transition back to a bullish stance is, I believe the key to telling the difference between fake rallies vs. real ones.

Let's go over a few characteristics and then try to put the pieces together for today's market.

First off, new bull markets typically do not start in a second. Every time the market has an up day, it seems analysts come out of the woodwork calling for a bottom. It has taken  time to repair the damage of previous bear markets. This is called base building. It is not very often the market will make a "V" off  the lows. During the year 2001, there were a couple of occasions where sudden rallies did occur. They were in January and the March/April period. During both those times, the market had no time to repair damage.

It was more or less snapbacks off of oversold conditions... kind of like we could be seeing right now three weeks after the terrorist attack.                                   

Technical Characteristics

I have described typical bear market rallies as having certain characteristics. Simply put, they happen quickly, they are sharp, they feel good but bury you quickly... after many investors are sucked in. This is what happened during the periods mentioned earlier. January's rally lasted all of three weeks and the March/April rally lasted 10 days before exhausting itself. Cries of a new bull market were heard across the land but to no avail. The market would not cooperate. These occurrences have happened in past bear markets  It is very tough to ignore these rallies. During these times, investors who have lost money are wanting to make it back any way, shape or form...usually jumping the gun.

Leadership

Practically by definition, all new bull markets have to have leadership. This is measured in how many New Highs there are and what the New Highs are. Quality names are key. I  also want to look for certain sectors that almost always have done well at the start of  new bulls... including Financials and Technology.
                                         
Follow-Through Day

Every new bull market that I have examined has started with a follow-through day, but not every follow-through day has led to a new bull market. There were a few of them that occurred this past year, to no avail.

Stocks Breaking Out                                               

The missing element of the past year's rallies was the ability for stocks to break out of trading ranges and hold their gains. Most failed. Until this changes, I expect that the markets will stay in the doldrums. 

Major Indices

You can't hide institutional buying and selling of the major indices. I believe that it is vital that you watch the general market at all times for changes in direction. In my view, this has to be looked at on an intermediate-term basis as well as long-term. Too many investors worry about each jiggle in the market. Get the big picture correct.

Sentiment

Sentiment is very important to me during bear markets. Up until August 2001, even after the major drops, sentiment remained bullish. 

I read sentiment several ways:

Put/call ratios: This measures the amount of panic on a short-term basis. Normally, investors buy calls because of optimistic views on the market. When the puts spike, it generally has meant that investors have become panicky. This ratio measured an all-time high reading not coincidentally on 9/21, the day the market put in its near-term bottom. Keep in mind, this is a short-term gauge.

Bullish vs Bearish: I measure this by reading the numbers from Investors Intelligence. They track newsletter writers and their stance. When they  become too bullish, the markets have usually dropped and vice versa. Up until August 2001, they remained bullish. They are now finally bearish.

Stock splits: When markets have topped, there have usually been a ton of splits because stocks have had a good run. When markets bottom, there are usually hardly any because most everything is down.

IPOs and Secondaries: At market tops, there have usually been a ton of them because investors continue to swallow them up. When the markets are bottoming, there typically are hardly any coming out because everyone is still afraid.

Margin debt: There is a direct correlation between past bull markets and margin debt going up and past bear markets and margin debt going down.

World markets: It is important to me that world markets are behaving. The worst bear markets in this country have usually been accompanied by bear markets around the world.

There are other things to look at but for me the most important are price action and volume. I have seen oversold markets get more oversold and overbought markets get more overbought. As of this writing, 10/10/01, the markets are in an uptrend after Follow Through Days on all the major indices. This has happened before. This latest rally started on the first attempted rally off the low on 9/21/01. It occurred as sentiment became as bearish as can possibly be measured by some of the indicators I mentioned. There still remain many cross-currents.

The Bearish Case

• The margin debt has dropped 12 of the past 17 months.

• World markets are still in major downtrends.

• Breakouts, while doing a little better, are still failing.

• This rally seems to be sharp and quick. It is also starting to feel good. You get the hint.

• Lack of leadership 

• Major indices still trading below moving averages.       

The Bullish Case                                

• Sentiment is still bearish.

• The markets are still moving up after their follow-throughs.

• The Fed has lowered rates nine times in nine months. This is unprecedented.

• All the news is bad.

• No stock splits.

• Hardly any IPOs or Secondaries.

Which way does the market go? Your guess is good as mine. I will just keep watching for clues.

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