A bear market rally is a temporary reprieve for bulls in an ongoing bear market, where the price of the commodity, stock or index (or whatever) whipsaws back up. This leads many to believe that the bottom indeed has occurred and that it is safe to buy in again.

Danger signs for recognizing a bear market rally:

  • Recognize that it is a bear market. This is, by far, the most important rule. It's also the most difficult to explain. It's not enough to say that a 20% drop in price is a bear market, as some stock brokers would have you believe. It's where the price action shows lower lows and lower highs, where the effect of news is magnified on the downside (the opposite of bull markets) and where the smart money has already left the table, realizing the fundamentals that do not support the inflated price can be hidden no longer...
  • The rate at which the price rises is uncharacteristically fast. Perhaps the best examples of this are possibly the rise in the Dow Jones Industrial Average after the initial fall from the peak in 1929. Study the period from late 1929 to 1932. One of the sharpest rallies in history occurred about a month after the peak, when the index had already dropped 20%.
  • Sentiment amongst the general public is still too bullish, despite the ongoing bear market. This is shown in the rally that went from November 1929 to mid 1930. More recently, the NASDAQ fall that is still ongoing from March 2000 has, at every called bottom, some stock analyst calling for new highs and for unreasonable targets for the rest of the year. Even today (April 2001), bullish consensus remains above 50% and the general public is still too bullish for this to be a meaningful bottom.

If you look at a graph of 1929-1932, you will find that I've described both a short term and a medium term bear market rally. The signs are slightly different for each but the message is the same. Bear market rallies are dangerous. They tempt the innocent investor to pile more money into a losing investment. In 1929, the people who lost the most money were not those who bought at the top because most of those got margin calls and sold out during the initial drop ... those who bought during the subsequent run-up were in it for the long haul ... to their subsequent dismay.

In fact, a more recent story comes to mind. There is a NASDAQ mutual fund called ProFunds UltraOTC1, which is, basically a fund that had the philosophy of "Hey, why stop at just being 100% in the NASDAQ 100 shares? Why not be margined on top of that?".

To quote the New York Times article I read,

The fund rose 188 percent in 1998, its first full year; 233 percent in 1999; and 49 percent in early 2000.

That was on the way up. On the way down, the leveraged nature of the fund meant that it basically lost 95% of its value from its peak sometime last week, before the recent rally. The strange thing about this is that redemptions from this fund have been minimal ("we're in it for the long term") and that the number of shares in the fund has actually ballooned, meaning that more investors have bought in ("it must be a bottom now. time to buy the dip"). The 95% drop means that even investors that had bought in and held for the entire ride up since 1998 and held for the entire ride down have now lost money but, in spite of all this, money flows into the fund anyway...

Well. It's still too early to tell the ultimate bottom for this cycle in the NASDAQ composite index but I suspect it will be far below the last closing price of 1961 on April 12th, 2001.

Caveat emptor in a bear market rally.

1: Source: http://www.nytimes.com/2001/04/06/business/06NORR.html

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