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A Sucker's Rally?

Submitted by Lance Roberts via STA Wealth Management,

In last week's technical review "The Mark Of A Bear," I stated:

"The Bulls have remained firmly in charge of the markets as the reach for returns exceeded the grasp of the underlying risk. It now seems that has changed. For the first time since 2007, as we see initial markings of a potential bear market cycle."

The problem in stating that we MAY be seeing the initial markings of a potential bear market cycle is that individuals assume this means the markets will crash immediately. When such an outcome does not occur, the analysis is presumed wrong.

However, it is specifically that denial that leads investors to jump back into the markets just before the ensuing crash occurs. This is known as the "sucker's rally."  As shown in the chart below, this may be the setup that we are currently witnessing.

With relative strength trending lower, volumes on advances weak and sentiment poor, it is highly likely that any bounce over the next few weeks will likely fail. 

A Look Backward

One advantage of technical analysis is the ability to look backward to get a glimpse at how the "madness of crowds" reacted in previous similar situations. While the past is by no means a perfect predictor of future outcomes, human nature tends to be quite insightful. 

2000

The chart below of "dot.com" bust shows many similarities between the behavior of investors then and today. 

As shown, during the market advance in 1999 the previous bullish trend support moving average tended to confine pullbacks in the markets. This supported the notion of "buying dips" as each decline from overbought (red dots above and below) to oversold (yellow dots) conditions set up the next rally in the ongoing bullish trend.

However, it is the TREND that we are most concerned with. 

Notice that beginning in August of 2000, the dynamics of the market changed. After breaking previous support levels, the markets retested the lows of a year earlier. (Sound familiar?) But, the subsequent bounce failed to move above what was previous the long-term bullish support moving average. 

It was at this very precise moment that the previous bullish trend ended, and the bear market trend emerged. 

As the Wall Street adage goes "the trend is your friend."

From this point forward, each oversold condition provided a "sucker's rally" to the now bearish trend moving average resistance. For investors, there were only fleeting opportunities to escape the "grasp of the bear" before the ensuing decline continued. 

It is during this bearish trend that "buying the dips" and "dollar cost averaging" into investments is a much less optimal strategy due to the inherent destruction of capital. 

2007

We can also see many similarities between today's market setup and that of 2007-2008 as well. 

I have again noted the bullish trend support moving average that contained the previous bull market that began in earnest in 2003. With the market trading firmly above the moving average, each corrective action to it provided an opportunity to add risk exposure to portfolios. 

However, as in 2000, the dynamics began to change in late 2007 and early 2008. Much like we have witnessed since the beginning of 2015, the market in 2007 began to trade sideways as internal dynamics deteriorated and momentum declined. 

Then, in December of 2007, which would be recognized as the start of the recession a year later, the market failed to climb above its previous bullish trend support. That failure led to the subsequent break of the lower support level (green horizontal line) that had been holding since the beginning of that year. 

As it was in 2000, it was at this precise moment that the bear market cycle officially emerged. Each subsequent decline to oversold conditions lead to a "sucker's rally" that failed at the now bearish moving average trend. 

The initial retest of the previous lows in March of 2008 ultimately failed. That failure, and each ensuing "clearing" rally thereafter, only provided brief opportunities for investors to reduce risk and seek safety from the "mauling of the bear."

As the bullish TREND turned negative, few investors were warned by Wall Street or mainstream analysts of the danger that was stalking silently behind them.

Tracking The Bear

While it is too soon to state categorically the next bear market has begun, it is worth noting the many similarities in today's market action relative to that of the previous two bear markets. 

As shown in the first chart above, the markets have:

  • Broken two important levels of support
  • Broken the bullish trend moving average
  • Exhibiting a deterioration of internal measures, relative strength and momentum

These were previously early indicators that something had clearly changed for the worse. But it was not untill much later that Wall Street, the media and investors looked backed and realized the obvious causes. It wasn't until a year later, in 2008, that the NBER looked back at much revised data and proclaimed the start of the economic recession rather than Bernanke's "Goldilocks Economy."

The markets are clearly sending the same warning signals that they always have. It is only a question of whether we are willing to listen, or allow our "greed" to keep us at the casino table hoping for one more "hot hand."

One thing is for certain, if the market does muster a rally strong enough in the week's ahead to retest the previous bullish trend moving average, it could very well be a "sucker's rally." Any failure will likely mark the beginning of a new bear market cycle. And, just as before, there will be no warnings, no announcements by the media, or acknowledgement by Wall Street analysts. However, the consequences will likely be just as severe.