Bear Market Rallies

Adam Hamilton     November 23, 2001     3173 Words


“It never was my thinking that made the big money for me.  It always was my sitting.  Got that?  My sitting tight!  It is no trick at all to be right on the market.  You always find lots of early bulls in bull markets and early bears in bear markets.  I've known many men who were right at exactly the right time, and began buying or selling stocks when prices were at the very level which should show the greatest profit.  And their experience invariably matched mine - that is, they made no real money out of it.  Men who can both be right and sit tight are uncommon.” – Legendary speculator Jesse Livermore, “Reminiscences of a Stock Operator” by Edwin Lefevre, 1923


Edwin Lefevre’s famous “Reminiscences of a Stock Operator” book, a thinly disguised biography of legendary speculator Jesse Livermore in the early 20th century, is required reading for every serious speculator and trader.  Lefevre’s masterpiece documents the incredible life of Jesse Livermore and is chock full of amazing market wisdom gleaned through Livermore’s hard-won life lessons learned by winning and losing real money.


“Worth” magazine once called Lefevre’s 1923 book one of the four greatest investment classics of all time.  It is one of the ultimate books for speculators to absorb and digest, as Livermore’s experiences and candid observations about the markets are totally timeless and will always apply as long as men engage in speculation.


I have read “Reminiscences” maybe a half-dozen times in my life, and each time I immerse myself in the incredible world of Jesse Livermore I emerge with a deeper and more fundamental understanding of markets and speculation.  I cannot recommend it highly enough!


Jesse Livermore started trading in the “bucket shops” (read the book) of early 20th century America at the tender age of 15.  He became so adept at trading that he was kicked out by the bucket shop owners (who were on the losing sides of his trades) so he sought his fortune on Wall Street.  He grew into one of the most colorful, flamboyant, and respected speculators of the last century, and was eventually known by popular names from “The Wall Street Wonder” to “The Great Bear”. 


In three decades of trading Livermore made and lost several fortunes.  His reputation became so notorious that he was blamed for the 1929 crash and for most of the big market breaks between 1917 and 1940!  Towards the end of his illustrious career in 1940 he wrote a fantastic book, “How to Trade Stocks”, that discusses his philosophy and rules for speculating.  He truly was a Wall Street legend and few understood the markets better.


In all the great trading wisdom of Jesse Livermore, I continue to marvel at his thoughts on preserving and enhancing capital.  In our opening quote above, Livermore is talking about the paramount importance of both patience and courage of conviction for the professional speculator.  He claims it was never his thinking that made him money, but sitting tight when he was right.


Think about that for a second.  One of the greatest speculators of all time emphatically believed that being right on the markets was relatively easy, but sitting tight was the great challenge.  Re-read Livermore’s opening quote above and digest this crucial speculating wisdom.


Like all timeless market wisdom, Livermore’s thoughts are at least as applicable today as they where when he first learned the hard lessons of the markets and passed them on many decades ago.  Investors today are being psychologically buffeted by the current chaotic frenzy in the equity markets.  Stock bulls and bears alike are marveling at today’s magnificent rally in US stocks. 


The bulls, not surprisingly, claim that the stock market is discounting a future recovery in early 2002 and that the ultimate long-term bottom for US equities was laid-in after the attacks in late September.  After periodically un-muting Bubblevision to listen to some of the guests over the past week, the popular bullish consensus seems to be that the great gains of the last couple months are the vanguard of a thrilling new bull market in stocks.  Investors are being told by Wall Street to buy now or else risk missing the coming recovery and bullish feast.


The bears on the other hand, also not surprisingly, claim this current action is little more than a spectacular bear market rally.  Although bears don’t appear on the mainstream financial media much these days except to be poked at with sharp verbal sticks and ridiculed by the bullish hosts, there are still quite a few surviving in the financial wilds.  The bears point out that bear market rallies are by definition extreme and spectacular, just like this one, so the bear market can lure more bulls to their doom as it slowly annihilates bullish sentiment.


Both bulls and bears alike are having their patience tested by the current action.  Since the great rally is losing steam and has run up so rapidly, the bulls are beginning to feel gnawing fear and doubt at the back of their skulls.  Are we due for a serious pullback?  The bears are also having a tough time, as they cannot believe, based on dismal fundamentals and the horrible economic news, how far and how fast the market has run.  Is this rally the real thing, the end of the bear market?  Doubts abound in both camps.


Are the bulls right, has the market really turned a corner into a new bull?  Are the bears right, will this rally too collapse in flames?


Maintaining patience and the courage of conviction to sit tight is becoming increasingly uncomfortable and difficult for virtually all stock speculators.  I have a sneaking feeling though, that if today Jesse Livermore was miraculously resurrected and shown the modern tools we use to trade, he would have little trouble seeing through the thick info-chaff and cutting to the heart of the matter to make the right decisions. 


Livermore had already learned patience and courage of conviction the hard way, by losing a lot of his own money, making subsequent fortunes, and losing some of those.  The great Saint Paul of Tarsus noted in his letter to the young Christian church at Rome that patience is only learned through tribulation.  Only by going through tough times can the hard lessons of patience and courage of conviction be fully internalized.  This ageless truth applies to speculating and trading as well.


While there really is no perfect substitute for going through market and financial tribulations and tough times yourself to learn hard lessons, we can all study other people’s market and financial tribulations and tough times in history and attempt to learn from their experiences and mistakes rather than making the same ones ourselves.


As Jesse Livermore noted how important it is to both be right and sit tight, we want to take a look at historical bear market rallies and compare current stock action to historic markets.  If the amazing equity rally of the last two months is really only a spectacular bear market feint, speculators and investors need to be exceedingly careful so they are not crushed in the next brutal downleg.


As always, history can graciously provide us with the priceless knowledge and tools to save us from making the old mistakes of the past all over again.  The knowledge of market history can help to grant us a proper perspective and help build patience and courage in our convictions on current market behavior.  A market perspective and worldview firmly grounded in history can help us make the right decisions now on how to play this current awesome market rally.


In order to study great bear market rallies, we chose a period of history that is the most famous bear market ever, the Dow Jones Industrial Average after the Great Crash of 1929.  Jesse Livermore was living, trading, and making fortunes during the bear market shown in the graph.  It offers some very valuable insights into the curious phenomenon of bear market rallies.



While examining the infamous chart shown above, it becomes quite obvious that there were six primary intermediate bottoms before the ultimate bear market bottom in 1932.  From the depths of these intermediate bottoms sprang forth great rallies that turned out to be classic bear market rallies.  They are marked with the arrows and numbers in the graph, with green showing the intermediate lows marking the beginning of bear market rallies and red showing the intermediate highs marking the end of bear market rallies.


While the series of waves oscillating around the primary bear trend appear more severe initially, in percentage terms each bear market rally is remarkably comparable in magnitude.  As the DJIA grinded ever lower following the Great Crash, each subsequent false bottom was made at a lower base.  With a lower base, the following spectacular bear market rallies could run up in similar large percentage terms even though they were much smaller in point terms as time marched relentlessly on.


Today, a bull market is generally defined as a 20% gain in a major stock index.  It is provocative to note that in the notorious early 1930s bear market, five of the six major bear market rallies gained more than 20%, allowing market analysts at the time to technically declare them to be bull markets.  If the six rallies’ gains are averaged, the average bear market rally after the 1929 crash weighs in at a very impressive 29.3% advance!


If you had been a contemporary of Jesse Livermore trading during this time, and Wall Street (which was then as bullish or more so than it is today) continually emphatically claimed that a bottom had been reached, would you have been able to discern that the bear market rallies shown above were really just vicious traps for bulls?


With the benefit of 20/20 hindsight it is very easy to discern bear market rallies.  Imagine holding up a piece of paper to cover the right half of the graph above, so you could not see the future after 1930.  Furthermore, in order to make the scenario more difficult, you have to realize that the vast majority of professionals and amateurs of the time were very bullish on stocks and there was occasional good news to goad the market higher.  Virtually no one knew that a depression was approaching like a juggernaut.  Recognizing bear market rallies in the midst of an actual bear is very challenging, but the rock-solid perspective of history helps tremendously.


Remember, there were six major false bottoms after 1929 in the DJIA each followed by an average bear market rally of 29.3%.  Investors who “bought for the long haul” in any one of these six great rallies were mercilessly slaughtered and did not make their capital back for many years into the future.  Indiscriminately buying into the top half of a bear market rally is a surefire way to quickly and efficiently destroy your capital!


In 1929 the speculative market of choice, where the Great Bubble manifested itself most severely, was the Dow Jones Industrial Average.  In the Great Bubble of 1999-2000, the speculative excesses were most concentrated in the upstart NASDAQ.  The moment the markets rally today, the NASDAQ still seduces much of the remaining speculative capital to flow its way.  The NASDAQ is certainly not the most important market today in terms of raw market capitalization, but it is by far the most important in terms of general market psychology.


The parallels between the two great bear markets are downright eerie!



Since the ugly NASDAQ crash of March 2000 there have also been six primary intermediate bottoms and subsequent rallies.  Undisputedly, five of these great rallies were simply deadly bear market rallies that helped lure more unsuspecting capital to its doom as it was utterly destroyed between the razor sharp teeth and gruesome claws of the famished bear.  The only open question remaining is whether rally six proves to be yet another deadly bear market feint or the glorious birth of a new bull market.


Provocatively, the average gain of the six major rallies we have seen since the NASDAQ crash is 28.5% as of market close on November 20!  As you recall from above, the six major bear market rallies in the DJIA after the Great Crash witnessed an average gain of 29.3%.  It never ceases to amaze just how close the present tracks history and how little really changes!


Why is that?  Why does seemingly ancient history matter so much for analyzing current markets?  The answer, of course, is that psychology is the single most important driver of short-term market performance.  (For comparison, realize that earnings and cashflow fundamentals are the most important drivers of long-term market performance.)  The endless ebbing and flowing of market psychology never changes.  It was important 100 years ago, is very important today, and it will be important 100 years from now.


While the long-term market oscillates around the ability of companies to earn profits for their owners, equity investors, the short-term market is driven by the human heart.  Human hearts are just as full of greed and fear today as they have always been in the past. 


When greed rules the roost, speculative manias such as the 1999-2000 spectacle occur and market prices are driven to nosebleed heights where they completely detach from reality for a short time.  As mania psychology peaks, the bubble markets soon stop accelerating upward and are dragged down under their own crushing weight.


Following episodes of widespread naked greed, raw fear takes hold, and people sell equities with reckless abandon initiating a downward spiraling vicious circle in which lower prices continually begat even more selling.  These greed and fear-driven oscillations of the market are the single most important responsible factor for short-term market action.


In bear market rallies, the fear caused by the preceding sharp fall is replaced by powerful, consuming greed.  Wall Street, investors, and speculators, most of whom are biased in favor of rising markets, see a small bounce, they assume the bottom is in place, so they start buying stocks, and a mighty bear market rally ensues which quickly feeds on itself and grows larger.


Interestingly, the biggest daily rallies in market history in percentage and absolute point terms occur in the midst of raging bear markets.  The best performing NASDAQ days in history did not happen before March 2000 while the bubble mania still lived, but during the two massive bear market rallies in the first half of 2001.  Bear market rallies are almost always extremely impressive and compelling!


Then, typically between three weeks and three months later, the bear market rally runs out of steam as greed once again abruptly morphs into fear.  Bulls who bought stocks in the bear market rally realize that earnings and the economy are not providing a sound fundamental foundation for the recent bear market rally and they begin selling.  The average bear market rally of the DJIA during the early 1930s lasted about nine weeks.  In the turbulent NASDAQ of the last couple years, the average bear market rally only had a lifespan of about six weeks.


Since it can be quite challenging to discern bear market rallies in real-time, it is absolutely crucial to maintain a proper strategic perspective of the markets in which the tactical market rally in question has emerged.  Is the overall market trend bullish or bearish?  Is the market over or undervalued in earnings and cashflow fundamental terms?  Are the overall economy and business profits getting stronger or weaker?


Obviously, if the primary market trend is bullish, if the market is fundamentally undervalued, and if the overall economy is improving, the odds are that any rally is the real thing and not just a deadly bear market trap.


But, on the other hand, if the overall market trend is bearish, if the market is fundamentally overvalued, and if the overall economy is weakening, the odds are very high that any rally is simply another bear market rally playing off short-term market psychology aiming to lure unsuspecting investors to their doom.


In the United States right now, primary bearish trends are well established, especially in the nexus of rampant stock market speculation known as the NASDAQ.  The US economy continues to weaken dramatically and corporate profits continue to wither.  This strategic background vastly raises the probability that the current tactical market action is simply another exciting but deadly bear market rally. 


Even worse, the US equity markets remain vastly overvalued in fundamental terms.  At the end of October, the NASDAQ 100 had a market-capitalization weighted average P/E of 39.8, the DJIA of 28.2, and the S&P 500 of 26.4!  (The new November valuation numbers will be available in the upcoming issue of our private Zeal Intelligence newsletter for our clients.)


A broad market P/E of 13.5 is considered fairly valued as it is the hundred-year average for US equities.  A P/E above 20 or so is considered overvalued while P/Es over 25 or so are historically hyper-dangerous bubble territory.  Current extreme broad-index valuations raise the probability to near certainty that we are presently simply witnessing an exciting bear market rally and not a wondrous new bull market.


In light of past market lessons, current market action, and the strategic market backdrop, the odds are vastly in favor of the bearish thesis that the current US equity rallies are little more than seductive bear market rallies that will ultimately collapse to new lows.  In this extremely dangerous time to speculate, investors and traders must have tremendous patience and deep courage of conviction.  They must ignore all the incessant extraneous market noise and make careful and prudent judgments on where to deploy their scarce capital based on fundamentals.


Unfortunately, most speculators and investors are not willing to study the past and the great wisdom of men who have been there and done that with real money like the legendary Jesse Livermore.  Most market participants, rather than learning from the hard lessons of others, need to go through their own tribulations and lose their own money to gain the critical attributes of patience and courage of conviction.  Because of this willful ignorance of how bear markets work, there are always hordes of investors ready to martyr themselves as bear market cannon fodder.


Like the unimaginably beautiful Sirens of Greek mythology, bear market rallies are incredibly seductive.  But, also like the Sirens, bear market rallies exist solely to lure investors to their doom on the jagged rocks of market fundamental realities hidden just beneath the pleasant azure waves.


Bulls, do your fundamental homework and carefully consider in your heart whether you truly believe this is the glorious birth of a great new bull market.  Bears, have faith in your historical research and knowledge, patience in your trading, and courage in your convictions during these turbulent market times.  As Jesse Livermore wisely noted, the “men who can both be right and sit tight” are uncommon, but they make the “big money”.


“Markets are never wrong, opinions are.” – Jesse Livermore


Adam Hamilton, CPA     November 23, 2001     Subscribe