When Will This Bear Market Rally End?

When is the market going to fall?

That’s the question I’m asked most often. And for good reason too.

Since the March lows, the Dow has rallied more than 45% in just 170 days. Throughout it all, there have been countless comparisons to the 1929-30 rally. A few months after the 1929 crash, the Dow put in a temporary bottom too. The index went on to rally 46% in 148 days. This has some bears saying the rally is living on borrowed time.

True – the rally has been strong and it is showing signs of slowing down, but it’s hardly unprecedented. The greatest stock market rally in history makes the current run-up look quite tame. In 1932 the Dow soared 111% in just 98 days.

That’s what is keeping the bearish sentiment so high. September is only a few days away. September, on average, is the worst month for stocks over the past 50 years.

Of course, monthly averages are hardly good at predicting the future. If they were, we’d all simply short the market in September and buy in December and January (two of the best-performing months) and retire.

The likely real reason for the average returns being so low is coincidence. Dragging September down has been the 1987 crash, Russian debt default in 1998, September 11 terrorist attacks, and last year’s meltdown.

That’s just a few bear arguments that I’ve heard in the past few weeks. I still believe this is a bear market rally and haven’t turned truly bearish yet (except in a few places – e.g. ‘hot” auto parts stocks). There’s no doubt a downturn will come. But here’s the three indicators you should watch for to see when the next leg of the downturn is coming.

Buying High and Selling Low

In a world filled with endless news flow, advanced technical analysis and all the ratios any investor could ever learn, it’s easy to forget stock prices are still driven by two forces – buyers and sellers.

Lately there have been a lot more buyers than sellers. (“Thanks for pointing out the obvious,” I know) The important consideration here is that the markets won’t take significant downturn until this changes.

Just look at what happened over the past few months. For 19 weeks in a row investors shoveled money into mutual funds. The Investment Company Institute, which tracks mutual fund inflows and outflows, says $185 billion has flowed into stock and bond mutual funds in the past four months.

This is a sharp contrast from last fall. That’s when we noted how investors pulling cash out of mutual funds were one of the key signs of a market bottom.

Mutual fund tracking firm Morningstar found that:

Mutual fund investors allocated more than $300 billion in new cash to equity funds in the bull market of 2002 to 2007 — with much of it put into funds when the market was near its highs. But in the ensuing bear market, investors pulled out more than $150 billion of assets — with the bulk of the withdrawals after the market melted down in September.

Clearly, the trend is a strong one. More importantly, it’s not one to bet against until it’s over. Basically, don’t try to call the top on retail investors which can continue pouring money into mutual funds. It can go on for a very, very long time.

Market’s turn when there’s no one left to buy. Up to this point, there are still a lot of willing buyers.

It’s not just retail investors sending more and more money into mutual funds though. There is also another important factor which precedes all major market downturns: complacency.

When No One Wants Insurance Anymore

There are a lot of ways to see how complacent the herd has become. You can look at the major headlines or track the commentators on CNBC. That, however, will only provide a very subjective analysis of the complacency in the stock market.

The best way to quantifiably track it is with the CBOE Volatility Index – a.k.a. “the VIX” or “Fear Index.” The VIX tracks the premium investors are willing to pay for option contracts against the S&P 500.

In other words, it’s the price big money investors are willing to pay for “crash insurance.” When it’s low, concerns about a significant downturn are low and vice versa. Right now, it’s hardly at a “crash imminent” high point.

The 2-year chart of the VIX below shows how the cost of “crash insurance” still hasn’t fallen completely back to pre-credit crunch levels – but it’s getting there:

The index is still relatively high compared to the “good times.” The index is still almost twice as high as it was before July 2007 when the market got its first whiff of the eventual impact of the sub-prime lending crisis.

This is a key indicator in that it shows how investors as a whole are more willing to spend less on insurance and put more of their capital “to work” elsewhere. Most big money investors are just looking for reasons to put their money to work. One of the big reasons they’re finding to do exactly that is next.

Great and Greater Expectations

We have a saying here at Q1 Publishing: great expectations usually result in great disappointments.

The opposite is true too. And that’s what we’ve been seeing this earnings season.

Consider this. So far, 480 of the S&P 500 companies reported earnings. Total earnings are down 28% from the 2nd quarter last year.

Normally, that’s terrible news. But when expectations have been factored in, it has turned out to be great news. An astounding 73% of the companies posted “better than expected” earnings. Only 9% were “in line” with expectations and a very low 19% failed to meet or beat expectations.

When expectations start to rise, which happens after a stellar earnings season like the last one, then it’s time to start betting against them.

Right now, earnings expectations are still in the middle of the road. They’re higher than they were, but there still not at lofty levels. If the next round of earnings is as strong as this one, then you can bet we’ll be facing a case of great expectations. But we’re still not there…yet.

Getting Trampled by the Herd

Now, these are just three indicators I watch closely.

Quite frankly, we’re at a nerve-racking point in the markets. If you want to bet big on a diversified mutual fund, the risk/reward ratio doesn’t justify it. If the S&P 500 runs up to 1200, you’re looking at a 20% gain. If it drops back down to 800, you’re looking at a 20% loss.

That’s why I recommend sticking to isolated opportunities within the big picture. We’ve reached a point where there will be the divide between the winners and the losers which will grow very wide.

As for the market as a whole, it reminds me of the late 90s stock market bubble.

If you recall, the Russia debt default blew up the infamously overleveraged hedge fund, Long Term Capital Management. The scare sent the markets tumbling. In response, the Fed chairman opened up the money spigots to limit the damage of a single hedge fund so closely interwoven into the financial markets it caused systemic risk. Sound familiar?

What followed, with the help of a great story in the form of Y2K, was the dot-com bubble. That bubble bled over into biotech stocks and, to a lesser extent, into large-cap stocks.

Everyone kind of knew it was overvalued, but everyone went along for the ride anyways. And for those who had discipline and who were armed with tools like trailing stop-losses, walked away with most of their gains in hand.

That’s why when it comes to this rally; its best keep a close eye on where the money is actually going. That’s where you’ll find opportunities. Also, it’s where you’ll see the real warning signals the party may be coming to an end.

By Andrew Mickey

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