Let’s make one thing clear from the outset. Value added by traders and investors during a “bear market rally” is worth just as much as value added during a bull market rally.

The difference is a matter of time frames. A bear market rally is generally a prelude to a subsequent decline that penetrates the prior lows.

Bear market rallies are a dangerous phenomena because they tend to be dramatic affairs that entice investors and traders to go long equities despite a lack of validation by solid fundamental and technical criteria. The decision to buy into such a rally is usually regretted by investors and traders when the market swiftly makes a move towards new lows.

After the peak of a bear market rally is reached, the decline is generally so swift that most investors are unable to exit the market at a price higher than their original entry basis.

Thus, the question: Is the rally that commenced on October 4 , 2011 a bear market rally?

What Is A Bear Market Rally?

First, we should define a bear market rally. Be advised that you will not find this definition in any trading almanac. This is my own definition. However, I believe that this specification will accord with general understandings of what constitutes a bear market rally.

  • A “bear market” is defined as a general stock market decline in which major stock indices decline by roughly 20% or more, from peak to trough.
  • A bear market rally is a significant general stock market advance (10%-25% from trough to peak) following a bear market decline that fails to capture the previous peak and/or sustain itself over said peak for ten or more consecutive trading days.
  • The requirement to recapture the previous peak is relaxed if the prior decline was particularly steepspecifically 25% or more. In this event, the criteria to disqualify the recovery as a “bear market rally” will be met if the recovery exceeds 33.3% and is sustained for ten or more consecutive trading days. (Note that recapturing a peak after a 20% decline requires an advance of 25%. Recapturing a peak after a decline of 30% would require an advance of 42.9%.) Note that an advance of 33.3% from a trough will represent a 100% retracement of a peak to trough decline of 25%.
  • To complete the definition of a bear market rally, after failing to capture and/or sustain the previous peak, the stock market must fall and penetrate the previous trough within a timeframe not to exceed two times the amount of time that elapsed between the original peak and original trough.
  • Disqualification as a bear market rally will be strengthened if both the bear market decline as well as the recovery that exceed the previous peak are “confirmed” by general market movements in which the S&P 500, Dow Jones Industrials, Nasdaq, Russell 2000 and Wilshire 5,000 all participate fully in the criteria set out above.
  • Disqualification as a bear market rally will be strengthened if the recovery subsequent to the bear market trough is “confirmed” by parallel recoveries (meeting the same criteria) by at least three of the following five cyclical sub-indices: Dow Transports, S&P Basic Materials, S&P Consumer Cyclicals, S&P Industrials and S&P Technology.
Based on the above criteria the current stock market recovery will be considered to be a bear market rally if the S&P fails to capture and sustain 1,371 for ten or more consecutive days and the S&P 500 ultimately declines to a level below 1,075 prior to August 9th, 2012. Confirmation by the other indices indicated would solidify the case for or against characterization as a bear market rally.

How Can One Recognize a Bear Market Rally?

Bear market rallies are like bottoms; you can only know for sure that they occurred in retrospect.

Thus, the challenge is to be able to identify the characteristics of a bear market rally as one is occurring so as to not get lured into one.

There are three main characteristics of a bear market rally.

  • Fundamentals continue to deteriorate. In a bear market rally, the fundamental forces that led to the initial decline are still in play and are in fact deteriorating beyond the level that was generally anticipated at the time of the trough. Stocks will often rally on relatively insignificant news during a bear market rallynews that in no way negate causes of the original decline. However, in a bear market rally, fundamental deterioration continues beneath the surface despite rising stock prices.
  • Sharp, relatively low volume advance. Bear market rallies are characterized by extremely sharp advances on relatively low volume. Such advances are driven by price-indifferent purchases by short sellers, put buyers and call sellers that are aggressively executing stop-loss orders. Furthermore, in bear market rallies the sharpness of the price increases indicate price indifference on the part of long investors. This is indicative of investor behavior driven by emotion rather than carefully considered fundamental and technical criteria. Specifically, such behavior indicates a fervent desire (frequently referred to as greed) amongst traders and investors to “not miss out” on a rally.
  • Sentiment recovers to extreme highs prior to recovery of prices. Stocks must typicallyclimb a wall of worry.” If sentiment indicators show extremely high levels of bullishness and/or extremely low levels of bearishness, this is an indication that the rally may not penetrate the prior highs. Extremely bullish sentiment suggests a high probability that reasonably foreseeable positive factors are already almost entirely discounted in the price of stocks.
Now, let us see to what extent the recovery since October 4, 2011 meets the criteria of a bear market rally.


The original stock market decline between May 2nd and October 4th was premised on fears of a significant global economic slowdown or recession. Two exogenous factors drove the decline in stock prices. The first factor was a potential economic and financial crisis in Europe. The second factor was a deterioration of the fiscal situation in the US beyond tolerable levels due to political dysfunction.

Both of these bearish drivers are still very much in play.

With respect to a crisis in Europe, for reasons outlined in detail here, a catastrophic economic and financial crisis in Europe appears more likely today than it did on October 4th.

With respect to the US fiscal situation, little has changed. US leaders seem just as far from reaching any sort of acceptable compromise as they were on October 4th.

Aside from these two factors, is everything as bad as it seemed on October 4th? No. It could be quite plausibly argued that recently released US GDP growth and economic activity data more generally (employment numbers ISM indices and etc.) have surprised on the upside relative to expectations on October 4th.

Ultimately, however, these factors do not trump the prior two points.

First, GDP and economic activity data may have been better than expected on October 4th. However, it is clear that the general trajectory of economic activity and earnings data is significantly down with respect to where expectations were at the peak on May 2nd. Indeed, consensus global GDP growth and S&P earnings estimates are considerably lower than they were on May 2nd and show very little prospect of returning to those levels any time soon. This suggests that it is unlikely that the market will surpass the May 2nd peak any time soon.

Second, the threat to the US economy that caused the original decline was never endogenous. The threats were always exogenous in the form of political inaction on the fiscal front and the crisis in Europe. Those exogenous threats have not gone away. To the contrary, they are exerting increasingly intense downward pressure on the US and global economies.

Thirdly, an exclusive focus on the improvement of US growth estimates since October 4th is erroneous. Well over 30% of S&P sales come from non-US sources and roughly 50% of net earnings. In this regard, it is important to note that global growth prospects have deteriorated substantially since October 4th. Even if the US economy manages to tread water, or even exceed current expectations in terms of growth, the severe deterioration abroad can drive down earnings expectations very substantially and serve as the fundamental basis for new equity market lows.

Finally, the original decline was partly caused by discounting of some given probability that various catastrophic risks might materialize. Specifically, these risks were related to the global economy and financial system. In this regard, the probabilities of catastrophic outcomes have only increased since October 4th.

All of this suggests that a sustained recovery above previous highs is not likely. To the contrary, all of these factors combined suggest a net deterioration of reasonably assessable fundamental prospects since October 4th. Thus, new lows are a strong possibility.

Character of Market Action

The advance from the lows on October 4th has been extremely sharp. It has been characterized by largeair pockets” and low volume.

One measure of the vulnerability of the advance has been the swiftness and intensity of pullbacks, as the “air pocketsleft behind are filled.

In these two critical respects, the advance since October 4th exhibits the classic symptoms of a bear market rally.

A 50% retracement (1,183 on the S&P 500) of the most recent countertrend high to the trough would offer another strong signal that the recent recovery will ultimately be categorized as a bear market rally.

What might change my view regarding the relation between the character of market action and the probability that the current advance is merely a bear market rally?

For example, if the market did a sufficient amount of backfilling and successful testing of key technical levels, the advance would become solidified. Furthermore to the extent that the advance were to become supported by rising volume and broader-based participation, this would suggest a stronger base from which the rally could sustain itself.

Sentiment & Market Psychology

Rallies typically must climb a wall of worry. In particular, after substantial bear market declines, rallies are fueled by a reversal of pessimism and skepticism. If there is no more pessimism and skepticism to reverse, the rally will tend to peter out.

Noted market commentator Mark Hulbert is of the opinion, based on his own sentiment indicator that tracks the level of equity exposure recommended by the newsletter advisors he follows, that the massive increase in bullishness since the October 4th low has been too great and the decrease in bearishness has been too rapid for the current advance to be sustained. The widely followed bull/bear ratio in the AAII sentiment survey tends to confirm Hulbert’s view.

However, in my opinion, other indicators tell a different story. Implied volatility as well as other measures of risk aversion indicate a great deal of residual fear and hesitation on the part of investors. Furthermore, even if investor survey sentiment is bullish, this does not mean that asset allocations have had time to adjust to reflect such new-found bullishness.

Thus, despite bullish sentiment data, I believe that investors on aggregate, are positioned quite defensively. I believe that they are positioned less defensively than they were on October 4th, for sure. But I also think that they are still positioned much more defensively than they were on May 2nd. This suggests that if good news were for whatever reason forthcoming, the stock market could rally significantly – indeed potentially beyond the May 2nd highs.

In sum, I do not believe that the third characteristic of a bear market rally can be applied to the present case. To the contrary, I believe that this factor suggests that the market has significant upside potential in the short term if news flow is favorableso much so that a test of the 1,371 is not out of the question on this basis.

What might change my view of this factor? Stubborn persistence of bullish sentiment in the midst of pullbacks would be a warning sign. Furthermore, evidence that the equity weightings of institutional investors and/or individuals had equaled or surpassed the weightings on May 2nd would also trigger a warning signal.


The preponderance of the evidence points to a high probability that the advance since October 4th will be viewed in retrospect as a bear market rally. Overall, fundamental trends and fundamental risks have deteriorated significantly beyond what they were on October 4th. Furthermore, the very sharp and low-volume character of the recovery off of the October 4th lows has been quite typical of bear market rallies. For these reasons, it is my view that investors should avoid being lured in by this recent advance. It is most likely a bear market rally.

As I have outlined in detail in previous articles, I continue to believe that within the next six months, the stock market will initiate a leg down that will penetrate the recent 1,075 low on the S&P 500 (^SPX) and ultimately take the index to a region between 950 and 1,020.

For this reason, I believe that all but the shortest-term traders should refrain from attempting to play the equity market on the long side through individual stocks or equity market proxies such as SPDR S&P 500 ETF Trust (SPY), SPDR Dow Jones Industrial Average ETF Trust (DIA) or Powershares Nasdaq-100 Index Trust (QQQ). I believe that investors with longer time horizons should raise cash and avoid purchasing or holding otherwise attractive equities such as Apple (AAPL), Microsoft (MSFT) and Pepsi (PEP).

Having said all of this, bearish investors and traders should not become overly confident regarding the prospects of a decline. Persistently high levels of risk aversion and the generally defensive positioning of investors mean that good news on any of the key fronts – i.e. Europe and/or the US fiscal situation – could fuel substantial rallies.

If investors want to know what would cause my current outlook to change – in either a bullish or bearish direction -- they can review the fundamental, technical and psychological criteria outlined in this article and my interpretation of these factors in prior articles. To the extent that any of these factors change, I will change my views accordingly.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I am long puts on a variety of cyclically sensitive indices. I am also short QQQ. I consider a region in the neighborhood of 1,295 to 1,300 to be the stop loss level for these positions.

November 14, 2011 2:08 pm

Sever the death spiral link of banks and governments

The financial fate of Europe’s banks and its governments are inextricably linked: because the banks are the primary source of funding for government deficits, government debt represents a large proportion of the asset base of most eurozone banks. Insolvency of one therefore threatens insolvency of the other.

The prevailing narrative is that this symbiosis makes the largest European banks too big to fail, driving eurozone governments to provide massive capital infusions and guarantees to banks during financial crises. The truth, however, is that, given the level of eurozone government indebtedness and the relative size of Europe’s banks, Europe’s largest banks are now too big to save.

The now inevitable restructuring of eurozone government debt will result in bank capital deficiencies which the International Monetary Fund estimates could exceed €300bn. European taxpayers cannot afford to cover this bill: tapping already thin public coffers will mean higher sovereign borrowing costs and dimmer prospects for growth. Even the strongest European economies now face this constraint.
Ultimately European governments will have to abandon their implicit guarantees for banks to protect their own solvency.
Equally, in the short term, governments cannot walk away from support for the banking sector without putting their own immediate funding needs at risk and potentially triggering the collapse of private credit formation in the eurozone with disastrous effects on the real economy.
These are the unfortunate facts: a number of governments will need to restructure their debts to bring them to a sustainable level; as a result, banks are going to need significant capital to absorb those losses; and, given the high level of government indebtedness across the eurozone as a whole, new sources of private funding needs to be found to cover those losses to get out of the death spiral of interdependency that eurozone governments and banks now find themselves in.
First, there needs to be an honest sizing of the problem, identifying those sovereigns whose current debt levels are hopelessly unsustainable as well as the level of debt relief required to restore sustainability.
Second, the European Banking Authority (EBA) must implement stress tests that take into account the identified need for write-downs of sovereign debt and the consequent bank capital that needs to be raised.
Third, the EBA should provide a deadline for affected firms to make up shortfalls from private markets or out of retained earnings.
Fourth, a federal financing body, such as the European Investment Bank (EIB), must provide a capital backstop should identified shortfalls fail to be met from private sources. To give it the firepower it needs for the size of the problem, the EIB must be empowered to raise debt supported by a stream of new tax revenues dedicated to retire the debt incurred.
Fifth, because the death spiral of interdependency makes further tapping of general tax revenues counterproductive, and collective credit support – such as through a leveraged European Financial Stability Facility, the eurozone’s bail-out fund – is constrained by the over-indebtedness of the member nations, the EIB’s capital backstop should be funded through a new federal tax on bank salaries and profits above defined levels.
Neutralising the long-term threat to financial stability of too big to save banks, however, will require a separate antidote. Using France as an example, assets at its five largest banks are over three times the size of the French economy. The disorderly failure of any one of them could cripple credit markets, not just in France, but throughout the eurozone. Yet France can no longer afford to save any one of them on its own.
Therefore, policymakers need to take a play from the antitrust handbook and break up any firm that is too big to save, thus removing a common threat to fiscal accounts and financial stability.
The one inescapable conclusion we must all draw from the recent financial crisis is that the so-calledglobal systemically important financial institutions” are not only too big to fail and too big to save, but most importantly, they are also too big to manage. The risks they run are too complex for the small group of managers at the top of any one of these mammoth organisations to fully grasp, for regulators to supervise and for investors to understand and discipline.
In the US, the Dodd-Frank act provides regulators with the authority to break up banks with more than $50bn in total consolidated assets that pose a threat to financial stability. Europe needs comparable authority. And regulators on both sides of the Atlantic must have the courage to exercise it.
Jim Millstein is chairman of Millstein & Co. He most recently served as chief restructuring officer at the US Treasury, where he led the rescue of AIG. Millstein was previously global co-head of restructuring at Lazard
Copyright The Financial Times Limited 2011.

November 13, 2011 7:57 pm

The only way to save the eurozone from collapse

As of last week, the eurozone no longer had a functioning sovereign bond market. The crisis has spread to France, whose bond spreads have approached Italian levels of six months ago.

The unfortunate accident of Standard & Poor’s mistaken publication of a French ratings downgrade tells us that the rating agency is clearly preparing a downgrade. It merely pressed the button too early. The European financial stability facility, the fragile and undercapitalised construction on which Europe’s rescue strategy rests, is therefore also likely to lose its triple A rating. The prospect of a temporary return of sanity in Italian politics eased the pressure a little at the end of last week. But this does not change the depressing reality that the eurozone may be only weeks away from a financial collapse.

I am hearing from Berlin that the German government believes that the arrival of Mario Monti as Italian prime minister is all it will take to calm the markets. This unsurprisingly complacent view misjudges the underlying dynamic of the most recent events.

The cause of the panic attack was the European Council’s decision on October 26 to renegotiate the private sector participation of Greek sovereign debt holders. With that decision European leaders destroyed what was left of a functioning eurozone government bond market. Investors interpreted itcorrectly in my view – as a precedent. They then dumped their Portuguese, Spanish, Italian and even French government bonds. As of now, there is only one significant risk-free asset in the eurozoneGerman government bonds.
The German government bond market is large and liquid, but not large enough to sustain the world’s second largest economy. The presence of a risk-free asset can hardly be overstated in a modern financial system. Each insurance company, each pension fund needs to invest part of its income in such assets.
Through a combination of short-sightedness and financial illiteracy, the European Council has now put itself in a position where it desperately needs Eurobonds, if only to assure the existence of a functioning financial sector.

Actually, they need a very large Eurobond. We have moved beyond the “blue-bond, red-bondproposal of the economists Jacques Delpla and Jakob von Weizsäcker (who last year proposed a clever scheme under which member states could issue new bonds under joint-and-several liability, but only up to an agreed limit and subject to certain rules).

What is now needed is something that affects not only new flows of debt, but also existing stocks. The German Council of Economic Advisors last week proposed an intelligent and ambitious scheme for what they call a “debt redemption fund”. Unfortunately, it suffers from the weakness that it is temporary. I am not sure that it is practical to launch a joint-and-several debt security as a pure crisis mechanism, and then to take it away a few years later.

The second reason you need a Eurobond is the effective collapse of the silly idea of leveraging the EFSF. Klaus Regling, the EFSF’s head, is wrong to say that market volatility has made it impossible to reach the leverage target. It was the other way round. The eurozone’s refusal to capitalise the EFSF properly contributed to the panic. A leveraged EFSF would have the worst kind of Eurobond: a tranche in a toxic debt security.

I really hope EU leaders will come to their senses and stop pussyfooting with dubious financial instruments. The eurozone needs a risk-free asset class, and this means something boring and simple.

Of course, the EU cannot introduce a Eurobond overnight. The most its leaders can do is to issue a credible statement of intent, and set in motion a process to enact the legal changes needed. It will take time.

But once they make such a declaration, there should be no obstacle to endowing the EFSF with a banking licence. The EFSF could announce that it would make unlimited purchases of national sovereign bonds to keep their spreads under an agreed cap – say 2 per cent for 10-year bonds.

The European Central Bank would refinance the EFSF for as long as it takes. Once the Eurobonds are in place, EFSF liabilities would simply be transformed into Eurobonds. This would not constitute an illegal monetisation of debt, as long as the endgame for the EFSF is credible.

The eurozone is thus without alternative. The introduction of a Eurobond will, in turn, require a broader and deeper economic government that extends well beyond the notion of a fiscal union. It would be more than a financial instrument. If it were to happen, it would catalyse further political integration.

But it might not happen. The crisis is moving too fast. We may well find that the Germans, the Dutch and the Finns are not ready for this. Their political leaders have certainly not prepared the ground for such a momentous decision. When the decision day comes, the day when the crisis reaches its bifurcation point, they might not be ready.

Unfortunately, we are now at, or very close, to that point.

Copyright The Financial Times Limited 2011.