Thursday, 24 January 2008

Beware of the Sucker's Rally

Before I get into the question of whether the latest stock market rally represents a sucker's rally, it's instructive to read the excerpt from John Hussman of Hussman Funds about how stock prices behave in bear markets.

Financial Markets Anticipate Recessions Before They are Obvious

It is crucial to recognize that the market downturns associated with recessions are never one-way movements. The basic feature of bear markets is that they maintain the hope of investors all the way down. The stock market often rides the Bollinger band lower, becoming more and more oversold, but will then unpredictably clear those oversold conditions by producing explosive advances that are fast, furious, and prone-to-failure.

The 2000-2002 bear market, which took the S&P 500 down by half and the Nasdaq down by more than three-quarters, included three separate 20% trough-to-peak advances in the S&P 500, and many more 5-7% rallies. We did capture a portion of those, but "clearing rallies" are always prone to failure, so we could remove only a fraction of our hedges. Unless we observe a very broad improvement in market action, that sort of trade would require more modest valuations than we see at present.

Generally speaking, when valuations are stretched (on normalized earnings) and both market action and economic measures have turned negative (as they have now), you can expect that buying-the-dip・will result in a brief feeling of genius and success followed by profound regret.

After dropping -24% from it's peak in November 2007 the XAO has rallied back more than 7% over the last 2 days. The big question is whether this is a sustainable uptrend or is it merely a sucker's rally? To attempt to answer this I thought it would be useful to have a look at past bear markets.

The chart below shows the 2002-2003 bear market. Of course there are many one or two day rallies but what I am concerned with here are the more major rallies. In this period there were 4 major rallies that failed to eventuate into a new uptrend.

The 1994-1995 bear market saw a similar decline from peak to trough as 02-03 and it also saw 4 major rallies that ended in failure before the market finally bottomed out.

The last example is the famous crash of 1987. From peak to trough the market gave up -50% in just 8 weeks. There were also 2 major rallies that lasted just a couple of days each, before the market pushed sharply lower.

There are definitely some similarities but ultimately all major market pullbacks have their own unique attributes. Returning to the question of whether the current pullback represents a sucker's rally. In all of the previous pullbacks shown above, none turned around on the first major rally and in fact in 2 of 3 cases above it took several attempts.

That does not mean that this time around will turn out to be the same. It is possible we saw the bottom after the record breaking 12 consecutive day decline ending on January 22nd. However I doubt it. I fully expect the XAO to run out of steam rather quickly and eventually head lower past the the lows of Tuesday.