Wednesday, January 19, 2011

The Characteristics of a Bear Market Rally

From Jeremy Grantham’s October 2003 Letter:

I concede that bear market rallies are a fairly nebulous concept because you cannot be sure what they were until later – the only proof of a bear market rally is that you go to a new low in the not too distant future. But despite this reservation, I cannot resist noodling with the concept.

The characteristics usually attached to a bear market rally are:

a. the prior low was not particularly cheap;

b. the leadership reverts back to that of the prior bull market;

c. the rally is sharp, unusually persistent while it lasts, and has a speculative tone, perhaps because investors are trying to make up lost ground;

d. investors’ hearts were only half broken by the previous low in the market, allowing confidence and speculation to recover rapidly.

And then some thoughts about that 2003 rally that are incredibly relevant today.

But, you may answer, this bear market rally is bigger in some ways (the Nasdaq is up over 50%, for example) than any previous bear market rally and certainly longer: no other bear market rally after the three great bubbles broke in 1929, 1965, and Japan in 1980 came close to this performance. And this is true! But it is also true that more stimulus and moral hazard has been offered to this rally than any previous one, by a wide margin. It is reasonable, therefore, to expect a big response and we are certainly getting it.

But Ben Inker, more cold blooded than I and less interested in semantics says, “Who cares what you call it, it’s going to end badly eventually because it’s overpriced.”