Bear-Market Rally Autopsy 2

Adam Hamilton     January 17, 2003     2988 Words

 

Life for stock and options speculators in the belly of this supercycle Great Bear market is definitely an interesting and exciting experience.  Bear-market trading is no-nonsense in-your-face hardcore speculation to the core.

 

In primary bull markets speculators can trade like investors and do just fine.  One diligently searches for undervalued stocks, buys them, and holds on to them until the markets recognize the valuation anomalies and bid up the prices of the stocks.  In bull markets the pace of trading is relaxed, as there is seldom any hurry to execute either buying or selling decisions.

 

While bull-market trading is relatively peaceful and reflective, bear-market trading is far more chaotic and less forgiving.  In a secular bear market there is only one major speculation game in town, riding the bear-market rallies long and the subsequent brutal bear-market downlegs short.  These major bear rallies seemingly erupt out of nowhere and unfold incredibly rapidly, waiting for no one.

 

While buying and selling now or a month from now in a secular bull market usually doesn’t make a massive difference in one’s ultimate trading profits, precise buying and selling in bear markets is absolutely crucial.  Any major trading decisions must be made by speculators within days or weeks of the optimal time to throw long or short to have a fighting chance of earning large profits.

 

Compared to speculation in a secular bull market, speculation in a secular bear market is vastly more challenging with only a razor-thin margin for strategic timing errors acceptable.  In the midst of a ferocious Great Bear, if you snooze you lose!

 

Since the great speculation game in the elite stock indices and options is riding the bear rallies up and shorting their subsequent collapses, we pay an inordinate amount of attention to the rhythm of the bear-market rallies.

 

I am occasionally asked why I discuss the stock bear and its speculation strategies so often in these essays and newsletters compared to discussing our gold and silver stock investments.  The answer is simple.  In the wonderful unfolding gold bull, all one has to do is buy the right stocks, wait a few years, and be blessed with mammoth profits.  Piece of cake!  Buying and holding to ride a secular bull, by definition, doesn’t require a Herculean amount of analysis nor precise timing after investment positions are initially deployed.

 

On the other hand, short-term bear-market stock-index and options speculation demands an enormous amount of effort and thought in order for speculators to emerge from the financial gladiatorial combat unscathed and with legendary profits to boot.  Timing is everything in this merciless game and the markets must be constantly monitored and evaluated in order to stay on top of the right trades.

 

Five weeks ago I concluded the first iteration of the “Bear-Market Rally Autopsy” essay with, “While it certainly could still run higher, the PCR sell signal discussed last week coupled with these decidedly bearish technical internals suggest the scales of probability are now drastically tilted towards the short side in the coming months. ... Take cover, as the bears are once again regaining the balance of short-term power.”

 

Now, almost 25 trading days later, the major US equity indices seem to be nicely confirming our bearish suspicions of early December.  Even the customary deluge of fresh January capital into the equity markets along with a phalanx of good news has not been enough to seriously challenge the old highs.  The bears are back in the driver’s seat and a wicked downleg is approaching!

 

The latest interim closing tops are still 939 on the S&P 500, 8932 on the Dow 30, and 1488 on the NASDAQ, which were all achieved on November 27th, the day before Thanksgiving 2002.  The trading action this week was critical in order to see if these latest tops would hold as overhead resistance. 

 

As of Wednesday January 15th, the data-cutoff date for this essay, the usual early January rally didn’t even launch a serious challenge.  One day earlier the S&P 500 came within 7 points, the Dow 30 within 89 points, and the NASDAQ within 27 points, which was apparently the best they could muster. 

 

Alas though, sadly for the increasingly desperate equity perma-bulls, there are no prizes for second place.  The markets possess zero compassion and destroy the wrong with extreme prejudice.  Only those fortunate enough to be right are blessed with survival and profits.

 

As long as the mega-index late November closing highs hold, there is no reason to even humor the thought of being short-term bullish.  Unless the markets prove otherwise in the coming weeks, the spectacular bear-market rally launched on October 9th is dead.  If you a are a short-term stock or index-options speculator and you have been dragging your feet on going short, your window of opportunity is rapidly closing.

 

Our latest dearly-departed bear-market rally, exposed naked for the world to poke and prod on the cold stainless-steel autopsy table, looks much like its ancestors.

 

 

With the benefit of 20/20 hindsight the massive bear-market rally that probably gave up its ghost in late November, Rally 3 above, was a quintessential bear-market rally.  It erupted with great fury and violence off of its October 2002 lows marking widespread general despair.  It shot towards the heavens like a rocket ship, scattering contagious optimism in its wake like some kind of ethereal glittering pixie dust.

 

Just like all major bear-market rallies, it hypnotized the perma-bulls with a seductive attraction exceeding even the legendary allure of the fantastically beautiful ancient Greek Sirens.  This vicious Great Bear enjoys toying with the bulls, occasionally leading them along in spectacular bear-market rallies just long enough to convince them to stay for their coming destruction.

 

With the enormous latent optimism built up that a spectacular 20-year bull market will inevitably spawn, our current Ursa Major has plenty of material to work with.  It still has a lot more work left to go until valuations are mauled back down under fair value and most of an entire generation swears to never invest in stocks again as long as they live.  Bear markets ain’t pretty!

 

Even the magnitude of our latest Rally 3 was roughly in line with the preceding Rallies 1 and 2.  The massive flagship S&P 500 index ran up 21% late last year, right in line with its earlier 19% and 21% gains.  As the S&P 500 is the biggest and most important stock index on Earth, we pay a great deal of attention to it and its volatility as we enter and exit our long and short index-options plays recommended in our Zeal Intelligence newsletter.

 

While the S&P 500’s gargantuan market capitalization of $8.0t dwarfs the NASDAQ 100’s $1.2t market-cap, the NASDAQ still remains disproportionately important because it became the very nexus of speculative excess in the monstrous 2000 tech-stock bubble.  The latest NASDAQ Composite bear-market rally at 34% was a bit anemic compared to its predecessors at 41% and 45%, but it was still of the right general magnitude, big. 

 

With the NASDAQ now averaging 40% gains in its major bear-market rallies, it is easier to understand why the perpetually beat-up bulls remain so gullible in zealously believing that every successive bear-rally bounce point is the end of the Great Bear!  For a while I thought they just enjoyed pain.

 

Interestingly, this trio of classic bear-market rallies has even more in common than the graph above suggests.  As I discussed recently in “The Bust in Review”, comparing market data across time is challenging because it all starts off different bases.  A 100 point gain when the NASDAQ is trading around 2000 is a 5% rally, but the same 100 points at a NASDAQ 1000 is 10%, a doubling in scope with the same absolute point change.  While the three rallies above look similar, they are not perfectly comparable when viewed normally.

 

As we try to continually gain more insight into these bear rallies to improve our own speculations and help us recommend superior trades to our newsletter subscribers, we decided to index the three massive bear-market rallies shown above to make them perfectly comparable.  The graphs below are the initial fruits of our labors.  They offer some interesting insights not readily apparent in a conventional graph like the one above.

 

To index these bear rallies, we assigned the market closes in both the NASDAQ and the S&P 500 at their respective initial bounce points as zero.  Then we assigned the market closes at their subsequent interim tops a value of one hundred.  All the rest of the closing data was indexed off these reference points, putting all the bear-market rallies on an effective common 100% scale for easy comparability.

 

While the Y axes contain this common indexed level, the X axes represent time in trading days.  Day zero marks the very top of each bear-market rally.  Negative numbers indicate days before the interim rally tops and positive numbers indicate days after.  For example, a -30 means 30 trading days before the bear-rally topped and a 20 indicates 20 trading days after a top.

 

Finally, Rallies 1, 2, and 3 are graphed below in the same colors in which they are circled in the conventional graph above.  The dates shown in the key for the three rallies below are the respective months each rally topped.

 

The yellow data below represents the early 2001 bear-market rally launched off the Greenspan Gambit of attempting to bail out stock bulls through frantic and reckless interest-rate slashing.  The red data represents the second bear-market rally erupting after the 9/11 tragedy.  The blue data is our latest specimen, the recently departed bear-market rally that the perma-bulls still somehow think is alive and well.

 

This unconventional indexed bear-market rally perspective is unique and offers many provocative insights.  The NASDAQ rallies are shown in this graph and the S&P 500 rallies in the last graph.

 

 

Bear-market rallies seem to faithfully follow a predictable pattern.  In the graph above under the color-coded rally key there is a white squiggly arrow that shows the general bear-market rally pattern.  Major bear-market rallies conform to this stylized behavior remarkably well.

 

Leading into the bounce point marking the birth of a major bear-market rally, the equity indices fall like rocks on increasingly negative sentiment and rapidly mushrooming general fear.  When all hope seems lost, the bear rallies erupt seemingly out of nowhere on staggering volatility and scream towards the heavens.  The bounces invariably form sharp patterns shaped like the letter V.  These “V-bounces” are very easy to discern in all the graphs in this essay.

 

At first only the bravest of speculators throw long anticipating the sharp bear rally.  In a market where most participants are petrified in fear it doesn’t take a lot of capital to force a rally.  After the rally runs up about 1/2 to 2/3 of its ultimate total distance, its near-vertical ascent moderates and its uptrend slows.  Eventually the interim top is reached with little fanfare when general greed is high and the perma-bulls are zealously proclaiming the bear market is officially over for the umpteenth time.  They never learn.

 

Then the rally fails.  The post-interim-top action is choppy with a general downtrend.  Violent mini-rallies lasting a few days punctuate the downtrend occasionally, but the markets start to slide faster and faster and it becomes increasingly obvious that the interim top was laid in weeks earlier.  As the markets continue to decay and once again approach their old lows, general fear ramps up dramatically and the slide grows steeper.

 

This sentiment cycle relentlessly driven by general investor greed and fear causes major strategic bear-market rallies and endlessly repeats itself until general valuations are ground down low enough to carve the real Ultimate Bottom when few expect it.  It is incredibly interesting and exciting watching these classic post-bust bear rallies unfold in the real world rather than just reading about them in dusty old tomes!

 

All three rallies above conform to this pattern.  Rally 1 and our current Rally 3 are practically identical on an indexed scale.  They both erupted around 35 trading days before their respective interim tops and their skyrocketing ascents are closely intertwined.  When I look at this magnificent symmetry I just marvel that anyone who has been trading for longer than a few months can mistake our current bear-market rally for anything other than just another bear-market rally!  If it walks like a duck and quacks like a duck…

 

The post-9/11 Rally 2 was a bit less condensed than the other two, which probably makes sense in light of the enormous uncertainty surrounding late 2001 after the terrorist strikes.  At the time there was anthrax in the mail, a coming Washington invasion of Afghanistan, and no one knew when another US city would be sabotaged, blown up, or nuked.  It was a difficult time to speculate with uncertainty growing exponentially.

 

Yet, even though events were definitely weird surrounding Rally 2, it did indeed conform to the pattern.  I find this tremendously fascinating that even the earth-shattering events of 9/11 were not powerful enough to override or short-circuit the normal greed and fear bear-market rally cycle.  Thankfully the free markets are fantastically resilient!

 

On our current NASDAQ bear-market rally shown above in blue, note the latest January mini-rally near the skull and crossbones.  It was sharp, it was big, but it didn’t carry us over the late November highs.  It also matches post-interim-top mini-rallies in the major Rallies 1 and 2 data uncannily well.  As this indexed chart makes evident, there was nothing at all technically special with the recent January rallying in US equities.  The young new downleg is still intact!

 

This provocative comparison is even more evident in the indexed S&P 500 bear-rally data.

 

 

Ominously, the indexed S&P 500 bear-market rallies, in the elite index that really matters in the grand scheme of things, are even less encouraging for the perma-bulls.  Now there is certainly nothing wrong with being bullish in either a secular bull market or during a short bear-market rally, but it is the height of investing folly to remain stubbornly bullish in the midst of a brutal Great Bear market!

 

The January S&P 500 mini-rally shown above in blue is the spitting image of a similar failed post-interim-top rally in the red Rally 2 data.  The Rally 2 data is also very instructive as it shows that a major bear-market rally can have multiple tops that almost reach the level of the primary top.  Rally 2 made 4 valiant attempts over many weeks at shattering its interim top, but it ultimately failed.  Until general S&P 500 valuations are forced back down to undervalued levels by the relentless Great Bear, odds are that every future bear-market rally will continue to fail until then.

 

Once again regardless of how many ways one slices the current Rally 3 data, it still looks exactly like a classic bear-market rally that failed in late November.  It fits the bear-rally pattern, its interim top has not been seriously challenged, and it has already displayed the characteristic sideways-downward decaying pattern immediately after its interim top that is common to almost all major bear rallies.

 

At Zeal we still remain heavily short the US equity markets via QQQ put options we recommended for our subscribers in the December issue of our Zeal Intelligence newsletter published a couple trading days after the November 27th interim top.  Thankfully it still appears that we were blessed with making the right decision at the time that the bear-market rally was probably over and deploying short-oriented speculative capital accordingly.

 

Our subscribers have already laid in strategic options positions which are still on track to blossom into legendary gains if this current US equity downleg is merely average like the last ones.  However if Bush’s goofy Iraqi adventure goes sour or stock-market fear becomes even more widespread this time around, our subscribers will probably have the opportunity to harvest fortunes.

 

With the natural tendency all we humans have to only be deceived and burned twice before we wise up, the increasingly obvious failure of the third major bear-market rally since early 2001 could really fuel massive selling pressure.  Bulls who believed the incessant Wall Street hype in the last two years are much less likely to tolerate staying long this time around in the now unfolding third downleg in 2003.  It could get ugly to the downside as the supercycle bust finally starts getting serious.

 

If you are not short yet and are interested in QQQ options speculations on the new downleg, it is not too late to deploy any of the trades recommended in our newsletter to our subscribers since early December.  The shorting window of opportunity remains open but I am not sure how long this will be so before greed wanes and put options premiums grow too high and risky.

 

If you are already short and playing along at home, the key numbers to watch are the November 27th index highs.  If the S&P 500, Dow 30, and/or NASDAQ close decisively above 939, 8932, and/or 1488 in the coming weeks then we will be forced to reevaluate our hyper-bearish near-term thesis.  If not, look out below!  These highs are the acid test for our extensive short-oriented options positions.

 

One of my personal favorite attributes of short-term speculation is its condensed time frame.  We don’t have to wait years to see if we will be blessed with a monumental harvest of profits or if we will be proven wrong and our options expire worthless.  This current bear downleg game only runs about six months in duration in the recent past downlegs, so the dust will clear and the potential king’s bounty if we win will be realized by late June 2003.

 

As this latest indexed bear-market rally autopsy shows, odds are the recent bear-market rally is dead.  Get out, or get short, or face the fearsome wrath of the ravenous Great Bear.  Beware the coming downleg!

 

Adam Hamilton, CPA     January 17, 2003     Subscribe