How To Spot a Bear Market Rally From a Mile
Bear Market Rallies are short term uptrends in the stock market, even when stocks are still in a secular bear market trend. These are also often referred to as "Sucker's Rallies." Generally, there are two kinds of bear market rallies - Short Term and Intermediate Term. Realistically, there cannot be a Long Term bear market rally - that would be referred to as a secular Bull Market instead! Let's take a look at their causes so that we can easily identify a bear market rally.
It is important to spot a suckers rally, and that too as quickly as possible, because that will help you get out of it before the trend returns to secular bear market. In other words, if you could successfully identify a suckers rally, it will help you avoid the stock market crash that follows. An added advantage is that you could make some low-risk short-term profits from a bear market rally.
Hope the next five minutes of your time will help you spot the next bear market rally.
Short Term Bear Market Rally
Such bear market rallies last from half a day to a couple of days.
One reason for such a rally is a temporarily oversold condition in the stock market, leading to bottom fishing by traders looking for small and quick profits. Such bear market rallies are sometimes called Deadcat Bounces. These generally happen when the stock market hits several week or month lows. Watch out in the print, TV or online media for headline news like, for example, "S&P hits 7-month lows," and you have spotted a short term bear market rally that would occur imminently.
Another reason is that even secular bear market conditions are dotted by some good news every now and then. Maybe some politicians talking up some reforms, maybe a financial expert making some comments that the worst is over, maybe the Federal Reserve attempting some drastic turnaround steps, or maybe Warren Buffet, Carl Icahn, or such high profile investors taking some action, like investing in a company that was affected badly by the stock market crash. Such inklings of good news would cause short term bear market rallies.
Once you spot such short term bear market rallies, you could take advantage of them by making use of those deadcat bounces to increase your short positions or your put-options positions. You will be able to short stocks at higher prices and buy put-options at lower prices, during these bear market rallies. When the stock market soon returns to its secular bear market trend, you make good profits.
It is very likely that the stock market would go through multiple short term bear market rallies before making a turnaround, or entering an intermediate term bear market rally. Hence, even if you miss the first couple of bounces, don't lose heart, just be on the lookout for the next one and take advantage of it.
Intermediate Term Bear Market Rally
These rallies occur when the market has already gone through multiple short term rallies or bounces.
One way to spot an intermediate term bear market rally is when the media become extremely bearish. Yes, that's strange but true. TV Shows like CNBC would be filled with talking heads that predict even lower values for the indices. For example, if Dow is presently at 7000, they would predict 6000 or even 5000 to be reasonable near-term targets. The same with websites like Yahoo Finance, Marketwatch etc. You would see articles lining up on the front page that portray nothing but utter bearishness, along with full justification. Once you come across such conditions in the financial media, you've successfully spotted an intermediate term bear market rally opportunity.
The justification for an intermediate term suckers rally is that by the time the media turns completely bearish, the stock market actually would have already taken the beating. Even the strong-minded bullish investor would now be ready to pull the plug due to the incessant bad news pouring in from all kinds of media. What else would you logically do when 99 out of 100 articles and shows talk about doom and gloom in the stock market?
Unbiased experts and market long-timers say that such scare-tactics are often used by the financial powerhouses and hedge funds to force even the strongest-minded investors to sell shares at dirt-cheap prices, so that the big boys can buy them, accumulate them, and sell them later at a price that's much higher than the multi-year lows set during the panic selling.
Another way to identify an intermediate term bear market rally is by the stock market going up even on hints of good news, or sometimes, less bad news. For example, if the GDP was expected to fall by 6%, but if the number came in at -5.75%, the market would go up in the case of an intermediate term suckers rally, as it is less bad news. Another example would be if a bellwether company's earnings is expected to drop by 50% year-over-year, and if the earnings come in at -48%, the market would rally as it is less bad news, once again. Please note that this would happen only when the shares of the company, and the market in general are already near their 52-week or even multi-year lows. The justification would be that things are not as bad as expected, hence stocks could be given the benefit of doubt towards the upside.
Both short term and intermediate term bear market rallies are usually helped by "short squeeze". This happens when traders who bet on the downside of the market by shorting stocks are forced to cover their positions. The longer the duration of the bear market rally, the more severe would be the short squeeze. You can spot a short squeeze driven bear market rally by looking at the volume of trades. If there are periods during the trading day where a stock rises very quickly on relatively thin volume, it is very likely due to a handful of traders reacting quickly to cover their short positions. That said, there can be high volume short squeezes too, if the stock is a heavily shorted one.
When you spot such an intermediate term bear market rally opportunity, you could take advantage of it by buying stocks of solid companies and holding them for a couple of weeks or more. Even if you miss the first few days of an intermediate term rally that's fine because you will get an opportunity to get in again at a later point, when there's a correction. You should set some realistic profit targets like 10% or 25%, and sell when you hit those targets. It is important not to be greedy during a bear market rally, or you would be caught in the downdraft which is sure to follow. Plus, you really can't predict when the suckers rally would end. Hence, it's important not to overstay your welcome!
There have been intermediate term bear market rallies lasting many months in the past too - for example, the stock market crash of 1929 was followed by a 3-month rally, only to be followed by an even deeper crash, culminating in the great depression of the early 1930's.
Patience is a major virtue in any kind of market - bull or bear. Let's say you mis-guessed the end of an intermediate term bear market rally and entered short positions or opened short ETF positions as outlined in the how to profit from stock market crash section, be patient and continue to add to those positions gradually. If you do enough research, if you read between the lines of earnings reports and economic reports, and if you are sure that you don't see signs of solid turnaround in the job market, retail sales, real estate and other facets of the economy, you will be rewarded for your patience with another stretch of stock market crash, when the rest of the investing public realize that this was yet another suckers rally. A word of caution about ultrashort ETFs is that it's not good to hold them for longer than a few days to a couple of weeks because their value keeps going down because of volatility decay due to the way such ETFs are structured. If you take a peek at the 6-month or 1-year charts of ETFs like SRS and SKF, you'll see that they shouldn't be held for longer periods.
Hope this helps you spot bear market rallies not necessarily from a mile, but right from your monitor! Always remember to set realistic profit targets and stick with them, when trading in a bear market rally.