Bear market survival guide: how to detect rallies and profit from them

After over ten months of being in a bear market, and having experienced three bear market rallies already, I thought it would be useful for my readers to know more about this kind of market environment. Also, since the October’s rally caught me in great surprise, making me cover my shorts and ending up with a negative monthly performance, I hope this article will help you not to make the same mistake.

Starting with the basics, a bear market is when a market experiences prolonged price declines: it typically describes conditions in which prices fall 20% or more from the recent highs, and it’s characterized by widespread pessimism and negative sentiment. Almost always, the causes of a bear market are of a fundamental nature, such as pandemics, wars, geopolitical crises, monetary policy changes, and paradigm shifts.

In bear markets, we must turn our thinking upside down in many respects: for example, since the main trend is downwards, a “reaction” is an up-move. Every leg down in a bear market is interrupted by a secondary reaction, which is a lifesaver for those who failed to take action when the market turned, and gives good entry opportunities to short again.

Usually, bear markets have four different phases. In the first phase, prices are high, and the sentiment is still optimistic: towards the end of this phase, investors begin to get out of the market by taking profits. In the second phase, asset prices drop sharply, trading activity and corporate profits decline, and many economic indicators begin to dip below average. At the end of this phase, some investors panic out, sentiment deteriorates and prices fall even more: this is referred to as “capitulation”. Then, we have the third phase, during which speculators enter the market, raising both prices and volumes. Finally, in the fourth and last phase, although prices continue to decline, they do so slower, and some good news start to attract investors again.

As of the time of writing this article, the market seems to be still at the second phase.

However, prices don’t fall in a straight line. Indeed, especially after the burst of a bubble, the declines during bear markets are often interrupted by a temporary reversal of the trend, which is then followed by a further decline: investors call this phenomenon “dead cat bounce”, but financial literature tends to refer it to it by the term “bear market rally” (”BMR”).

Bear market rallies are vicious and violent, as they force short-sellers to cover and give optimistic hopes to those who are still positioned long. Taking the dotcom bubble burst as an example, the peak for the NASDAQ composite index was in March 2000. Just a bit more than two months later, the index had lost over a third of its value, but it rose by 33% in the eight weeks that followed. At that point, the total drawdown from the peak of March was just 15%. However, after this short-lived recovery, the market started to drop again, hitting new lows and ending up with a total loss of roughly 80% from the peak. Cumulatively, buying the top of each bear market rally and selling the bottom would have totaled a loss of 86%.

The Global Financial Crisis of 2007-2009 was marked with repeated bear market rallies, too: total drawdown in the S&P 500 index was -56%. Cumulatively, buying at the top of each bounce and selling the bottom would have totaled a loss of 80%.

Bear market rallies over 2007-2009 decline.

Generally speaking, although many reasons are given for every move of this kind, the bear market rallies serve two purposes: they correct a primary market movement that has gone too far in one direction, despite the underlying economic reasons for the primary trend not having changed enough to cause a reversal of it; and they dampen the speculative ardor of amateur traders.

“One of the greatest pieces of economic wisdom is to know what you do not know.”

J. K. Galbraith

It’s clear then that these secondary reactions are of extreme importance, although most investors have great difficulty in recognizing the advent of them. To make things even worse, the bear market rallies are often mistaken for a true reversal of the primary trend.

According to Investopedia, a dead cat bounce “can be a result of traders or investors closing out short positions or buying on the assumption that the security has reached a bottom”. However, according to cumulative prospect theory studied in Johannsen’s work, preferences lead the investor to take high risk and unprofitable investments in the hope to recover losses experienced after the burst of the bubble, which leads to a jump in demand for the individual investor.

It’s interesting, then, to note that the higher the share of unsophisticated investors, the higher will be the extent of the bear market rally: indeed, a higher share of holdings by unsophisticated investors during the peak of the bubble increase the probability that a price reversal happens at a later point. Also, the larger the optimism during the build-up of the bubble, the higher the probability of a dead cat bounce and the larger its expected size.

Considering these two factors, it’s unsurprising that the rallies over this year have been so violent in their moves: the past two years provided the market inflows of capital from retail investors, who, blinded by the incredible returns, convinced themselves to be great traders and understand the economy perfectly. Little did they know, though, that their returns were simply a result of loose monetary policies, historically low interest rates, and increasingly higher system liquidity. By understanding the macroeconomic environment we find ourselves in, it’s easy to say asset prices will continue to fall, at least until the monetary policy stance changes or the economic data shows signs of improvement. At the same time, it’s just as simple to see why every single rally this year was fueled by the “Fed’s pivot” narrative.

In bull markets, most reactions end with a day or so of heavy volume, a characteristic that can be of real use in identifying the bottom. However, a primary leg in a bear market may or may not end on heavy volume: the determination of a bear market leg and the beginning of a rally cannot always be spotted by volume indicators alone. Often, after an extended bear market decline, there will be a day or two of high volume: if the decline then continues, but volume shrinks drastically, the odds favor an early reversal.

Citing Rober Rhea: “A study of secondary reactions in bear markets will reveal that the development of those movements is usually indicated by a series of minor rallies and declines, with each rally generally carrying above the preceding one, and declines terminating above immediate preceding lows. Such a formation in the averages forecasts a secondary advance, even though the primary trend is down.”

A rule of thumb to recognize a reversal in a bear market is, then, to watch for a rally high closing above a prior rally high, then dipping, but holding below the former low: when you see this in a bear market, it’s time to assume the new trend is up.

Below, the chart of the S&P 500 index price action between September and October 2022, with the reversal highlighted.

The rallies seem to spring from no visible base or area of support: they invariably result from a technical condition in which the market becomes oversold. While smart short sellers realize this is the perfect moment to cover, amateur ones, having made their move too late, quickly follow them. Then, floor traders, sensing the reversal, start buying, fueling the rally. After all of that happened, news outlets make up some story to justify the rally.

Directly from the book “Bear Market Investing Strategies”:

“During secondary reactions in bear markets, it is a fairly uniform experience for traders and market experts to become very bullish. They are usually bearish about the time the upturn comes. The converse holds true of the psychology that precedes a bear market rally. Here, boardroom “oracles” are gloomy, investment services are pointing out the advantages of bonds and defensive stocks, and neophytes are trying their hand at shorting. The bad news, which already has been discounted in the downward swing, is appearing on all sides. At such times, a bear rally is in the making.”

Luckily for us, identifying the top of a bear market rally is easier than the beginning. Indeed, citing Rhea once again, “if after the high point has been attained, a further rally shows a definite diminution in activity, it is probable that an early resumption of the decline will occur”. Dullness following the peak of a bear market rally is a common danger sign: in a bull market, dullness is usually followed by advances; in a bear market, by declines. For example, the best indicator for late stage bear market rallies are market participants starting to call a “new bull market”, or people starting to get emotional over the possibility they could recover all the losses from the bear market.

But we have always to keep in mind that the reason prices go up in a bear market rally is due to the technical conditions becoming too stretched, not because of fundamental improvement. Beware of the ones telling you otherwise. Another way to detect the end of a bear market rally is to look for market momentum exhaustion and high probability zones of reversal based on volumes and order book.

In conclusion, to profit in a bear market, it’s essential to learn the signs of a secondary market reaction. If one is a long-term investor, which in a bear market means he holds short positions for the entire life of the bear market, then he can ignore these secondary reactions: however, especially if one wants to be able to sleep well, it’s better to move in and out of the market in conjunction with secondary movements. Short-term traders can indeed profit more from these moves, by selling the rallies and buying the lows, but odds are they are going to lose more than they make by doing that.

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This article wouldn’t have been made possible without reading “Bear Market Investing Strategies” by Harry D. Schultz, which you can buy from here.

Also, the article takes great inspiration to Kolja Johannsen’s work, titled “Dead Cat Bounce – Demand Reversal Following the Bursting of a Bubble”, that you can find here: