If You Think We’re In A Bear Market, Don’t Be Fooled By The False Rallies

If You Think We’re In A Bear Market, Don’t Be Fooled By The False Rallies
Stéphane Renevier, CFA

almost 2 years ago2 mins

Mentioned in story

Stocks have shown a surprising run of form lately, with the S&P 500 recovering 12% promptly after having dropped 15% a few weeks ago. But that doesn’t mean we’re not in a bear market. Take a look above at the bear market of 2007-2009: the S&P 500 experienced multiple rallies – of 11%, 7%, 12%, 7%, and 24% – even as it fell 57% from its prior peak. So while stocks have recently popped higher, it’s very possible that we’re already at the beginning of a longer-term market downturn.

Trouble is, it’s not necessarily easy to turn a profit even if you suspect we are in one – mostly because it’s so difficult to tell a real rally from a false one. Let’s imagine you’re trying to profit from a market downturn: you short the S&P 500, only to second-guess yourself when the market starts bouncing back. So the temptation to cut your losses overtakes you, and you close out your position. Then the false rally loses momentum and stocks collapse again. But now you’ve burned through your capital, and you’re no longer in a position to buy in on the cheap.

There are two ways to make sure this doesn’t happen if you think we’re in a bear market today. The first is to try to identify false rallies when you see them. You should try to focus as much as possible on the longer-term picture: avoid looking too frequently at market prices and headlines, and constantly ask yourself if anything has fundamentally changed for stocks. You should also try to open your short positions when prices have rallied, and close them after prices have fallen. When volatility is high, it pays to be contrarian and go against short-term price action.

The second option is to… do nothing. Seriously: you might be better off not betting against the market and simply stomaching the paper losses that come with long-term horizons. They won’t matter in the long run, and it means you can wait until opportunities emerge to buy stocks on the cheap.

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