Bear Market Rally or Return of the Bull?
Unpacking Bear Market Rallies
The stock market officially entered bear market territory in mid-June, dropping 20% from its peak and setting off alarm bells throughout the investment community. However, over the summer months, the market has slowly crept back up, with the S&P 500 rebounding by over 19% and building consistent gains week after week. So, was this bear market just extremely short-lived? Was it even a “real” bear market? While experts hold different views, we aim to get to the bottom of the issue and figure out wether we are in the midst of a so-called “bull trap”. But first, let’s start with a couple of definitions.
What is a bear market?
The traditional definition of a bear market, that is also used today in mainstream media is a decline of 20% or more in the price of an asset. This was the broad measure that worked for decades in the investment community, as a 20% drop in prices achieved several key points:
A valuation reset
Broken technical setups
A “risk-off” mindset for investors
While the price drawdown of the S&P500 certainly exceeded the 20% benchmark (-23.41% achieved on June 17), we are struggling to find evidence that all of the other points were reached. Using our stock screener, we isolate the top 1000 stocks by dollar transaction volume (column D), we compare 2 year average valuations (A, P/Sales) to current valuations (B), and get the discount (C). Also, on column E, we compute the average Max Drawdown of the past 2 years for this group of stocks.
We find that Price to Sales valuations dropped from an average 7.56 to 6.76 (or around a 10.5% decline). Taking any given stock, you would expect to find a valuation discount of just 2%. Around 70% of these companies are still in a Positive Regression Trend. The only indicator of a bear market is found on the Max Drawdown column, with declines notching -42.1%. Note that if we were to restrict the screener to just the top 100 stocks by 2 year average valuation, their Max Drawdown would be -53%. Investor psychology has barely changed, in this timeframe, with plenty of institutional and retail flows into equity funds.
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What is a Bear Market Rally?
We’ll define bear market rallies as periods of rapid price appreciation that last a number of weeks up to a couple of months, which mislead investors and make them believe that a recovery is happening. Throughout history, average bear market rallies return 17.8% of gains before nose-diving to even further lows. Average gains that qualify in this sense since the start of the year average 12.71%.
Source: https://www.global-rates.com
Looking at History for Guidance
We all want to avoid falling victim to a bear market rally, though sometimes, even the most experienced investors find themselves in a sticky situation during these upward swings. Historically, there have been 30 bear markets since 1929, with an average decline of 29.7% and an average duration of 341 days. The current decline has notched around 235 calendar days.
When examining some of the most notable bear markets, such as the tech crash between 2000-2002, bear market rallies happen multiple times during lulls in the market. That one, for instance, experienced four rallies that had gains ranging from 10% to 25% before spiraling downward.
Guiding Signals to Watch
Fibonacci retracement levels are a technical indicator that have historically had success at predicting the end of the bear market and the start of a bull market. Since 1946, the 13 bear markets have all ended when the S&P 500 cleared its 50% retracement level. This time around, the S&P 500 cleared its 50% level, but fell back below it. Yesterday’s price action stopped just short of this level yet again. We are inclined to also used the “Gamma Neutral” level, which options dealers use to hedge exposure. Prices above this level indicate buying interest on dips. If prices close below the “Gamma Neutral” level, options dealers are more likely to sell declines and buy rallies, exacerbating volatility. This level stands at 415 - 420 currently, on SPY.
Avoiding the Trap
We know how psychological trading is; investors can get spooked from one bad day and sell everything, or as is seen in bear market rallies, become over-confident and see false signals to buy, only to be devastated in the following weeks when a tsunami hits. While the current rally may be showing signs of fatigue, the most important guidance is to be patient and move SLOWLY and carefully. Emotional behavior is your worst enemy when dealing with the market. While our investing models may get aggressive and heavily allocate towards risk, the real life approach calls for a steady and measured build-up of positions.
Fundamentally speaking, inflation and interest rates have been at the forefront of every investment conversation this year. The chairman of the Federal Reserve, Jerome Powell, is expected to make statements later today, on the Fed’s sentiment around hiking interest rates even further this year. Though the drop in inflation numbers in July seemed to cool some anxiety in the market, analysts are expecting Powell to maintain an aggressive stance on rate hikes, even if it pushes the market into a recession. This is the crux of the bearish case.
The bulls note that a Fed “pivot” is in the books and the worst has already been priced into stock prices. Technicals also favor the bullish case, both on a market-wide scale and just using SPY as a proxy. We compare average Z-Scores for the top 1000 companies by dollar volume and SPY and find that individual stocks are faring better from a technical perspective than the S&P index. (-0.51 broad market vs -0.8 SPY). Values above -1.0 are considered investible using our methodology.
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CONCLUSION
My own take is that what we have seen so far in equities does not qualify for the full meaning of a “bear market”. Valuations have not reverted to the extent required by a true “reset”, investor psychology has barely changed, despite heavy losses in the crypto space and speculative stocks, and whatever technical damage has been done to the broad market has been repaired so far.
Our reasoning stands that since there has not been a “bear market”, current action is not a “bear market rally”. Rather, we are witnessing a correction within an ongoing bull market trend. As such, we are treating the current setup as an investible opportunity. As far as support levels hold, we will keep adding equity risk exposure according to our target allocations set by Signal Sigma strategies. Trading positions will be kept on a short “Stop-loss” leash, however.
Andrei Sota & Jerica Kingsbury
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