The Illusion of an Uptrend
When it comes to bullish stock investors, the recent explosive rally in the stock market following a better-than-expected report on inflation might seem incredibly promising. However, it is crucial to temper this enthusiasm and take into account the historical trends surrounding such rallies.
Bear Market vs Major Uptrends
An analysis of the Nasdaq Composite since its inception in 1971 reveals an interesting fact: just under one quarter (24.5%) of all trading sessions occurred during bear markets. This information, gathered by Ned Davis Research, challenges the assumption that huge one-day spikes occur randomly across the calendar.
A Surprising Data Pattern
Taking a closer look at the Nasdaq Composite’s trading history, we find that out of 25 trading sessions with the biggest one-day gains, a staggering 80% of them took place during bear markets. This starkly contrasts the anticipated proportion under the assumption of randomness. Similarly, when examining the 100 trading sessions with the biggest gains, 60% of them occurred during bear markets.
A Wider Lens on History
This pattern of substantial gains during bear markets extends beyond just the Nasdaq Composite. The S&P 500, dating back to 1928, and the Dow Jones Industrial Average, spanning its creation in the late 1800s, also follow a similar trend.
Making Sense of it All
Upon reflection, there are three reasons why this seemingly counterintuitive pattern actually makes sense:
- Market Vulnerability: Bear markets inherently exhibit greater volatility and vulnerability, increasing the likelihood of rapid upward movement.
- Discounted Prices: During bear markets, stock prices are often significantly discounted, making it easier for stocks to experience larger percentage gains.
- Traders’ Behavior and Confidence: Bear markets can trigger opportunistic behavior among traders, leading to increased buying activity and subsequent price surges.
In conclusion, while huge stock market rallies may initially appear promising, it is imperative for investors to exercise caution. Historical data shows that such rallies are more likely to occur during bear markets rather than in major uptrends. By understanding the underlying reasons for this pattern, investors can make more informed decisions when navigating the uncertainties of the stock market.
Sentiment
Bear markets thrive on an eagerness to believe a new bull market has begun. Investors are always quick to jump back on the bullish bandwagon at even the smallest hint of hope. However, bear markets typically don’t come to an end until investors completely give up on equities. This pattern is evident in investors’ behavior following this month’s inflation report, as they continue to hold on to the “slope of hope” that bear markets often descend.
Volatility
Comparatively, bear markets are more volatile than bull markets. In fact, the biggest one-day plunges and rallies tend to occur during these bearish periods. Take, for example, the Nasdaq Composite’s history since 1971. Out of its 25 largest daily declines, a whopping 84% happened during bear markets. Similarly, approximately 80% of the biggest one-day spikes also occurred during these bearish phases. This stark contrast emphasizes newsletter editor Jon Markman’s apt description of bull market psychology versus bear market volatility: “during bull markets, stocks tend to rise at a leisurely and thoughtful pace, like an 80-year-old couple out for a walk in the Florida sunshine.”
Compensation for Risk
The compensation for risk is closely intertwined with volatility. To account for the increased volatility in bear markets, the stock market must offer a higher expected return. In order to achieve this, the stock market must first experience a drop to lower levels that hold greater upside potential. Consequently, it’s no surprise that bear markets and periods of high volatility often coincide.
It’s important not to get carried away by momentary movements in the market. Even though the rally following this month’s inflation report appears impressive, it is crucial to remember that one day alone does not signify a major uptrend.
Mark Hulbert is a regular contributor.
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