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What Is A Bear Market Rally?

justin freeman
Justin Freeman trader
Updated 21 Nov 2022

Seasoned and intermediate traders alike are sure to have encountered the terms ‘bull’ and ‘bear’ when referring to the state of the market. While ‘bull’ is used to define a favourable market of rising value, what does a bear market apply to? Notably, at the time of writing, the S&P 500 is down 20% year-to-date. Similarly, the FTSE 100, priced in USD, is down by 20% year-on-year. A figure of 20% is an oft-referred marker for a material shift in valuation and indicative of a trend over the noise – as highlighted by the World Economic Forum. With a degree of certainty, such a state can be classed as a bear market.


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What Is A Bear Market Rally?

In reality, 20% is nothing more than an arbitrary figure that fits the average of a material decline in the minds of a swathe of investors. The very definition of a bear market is linked to the 20% threshold – market watchers suggest that a 20% reduction from recent highs is the technical definition of a bear market.

It is evident then that at the time of writing, we are most definitely in a bear market. At such a time, traders will have inevitably taken defensive measures and positioned their portfolios to weather the storm. Alternatively, those of a more adventurous disposition may be actively seeking out the tempest for investment opportunities.

For the investor looking to dip a toe back in the markets, Asktraders has come up with the below shortlist of considerations for those anticipating a bear market rally. Read on to uncover our definition of what precisely a bear market is and what consequences it could have on your portfolio.

Bear Markets And Bear Market Rallies

Bear markets tend to be relatively short-lived compared to their bull counterparts. According to Hartford Funds, the average bear market lasts 289 days. At the time of writing, we have passed the 289-day marker from the highs at the start of the year. With that being said, under the same analysis, the average loss in a bear market is 36%, so by that measure, there would be a way to go yet from the current drop of 20%.

A bear market is most often paired with an economic downturn, but that isn’t necessarily the case. With inflation well above the 2% target set by most policymakers and productivity trending negatively, the outlook for the global economy certainly adds weight to the likelihood of a longer-duration downturn in the global markets.

A bear market rally is a period in time in the markets or of a particular security that sees a short-lived rally in the valuation before returning to the downward trend. For medium, to long-term investors, the bear market rally is false dawn on an otherwise arduous downswing.

Other terms for a bear market rally include ‘dead cat bounce’ or a ‘sucker rally’. The colourful language and manner of these phenomena are suggestive of the insincerity and insecurity in such a pattern and are intended to forewarn uninitiated investors.

composition of a bear market rally
Source: iStock

Composition Of A Bear Market Rally

A short and sharp rebound in a price that has fallen for some time is oft-referred to as a bear market rally. The ferocity of a price rebound may fool the naïve investor into thinking there is real staying power in the price action.

The most common cause of a bear market rally is one in which short-sellers are taking a profit. Short-selling is the action of borrowing stocks in order to sell them to other market participants. When the stock has fallen below the short-sellers’ target price, the stock is rebought more cheaply, the loaned stocks are returned to the custodian and the short-seller pockets the difference in price.

When enacted en masse along with natural selling, short-selling can cause a stock price to decline quickly as the sellers outweigh the buyers. As investors either consciously or unconsciously act in unison to take profits on short-selling, the sharp uptick in buying can cause the price to rally quickly.

This is not suggestive of a turnaround in the business conditions of the stock of the company but simply profit-taking. The most likely next action in the price will be to the downside once the short-lived rally is over.

Bargain hunters can also be found to drive short-lived bear market rallies. When a stock has sold off considerably, investors may start to believe that a stock is on sale, and similar to the Black Friday rushes, unconscious herding develops with everyone trying to get a bargain at the same time.

Though extremely common in the stock markets, this type of herding behaviour is misleading and very rarely a fair representation of the change in business fortunes or outlook of a company.

After all, changes in business strategy, marketing campaigns, and the execution of a listed company’s operations take many weeks, months, and years to complete. The measurement of the success of those actions then adds weeks to that timeframe. A short-lived rally timeframe will very rarely be long enough to digest an investment cycle of information and be reflective of a true reversal in a company’s fortunes.

How To Identify And Trade Around Bear Market Rallies

When it comes to the identification of a bear market and pinpointing the relevant conditions to trade, there are a number of strategies and procedures to remain aware of. Let’s continue as we break down the following points:

  1. Be aware of your surroundings
  2. Lead with your head and not your heart
  3. Implement sound risk management
  4. Review and understand

Be aware of your surroundings

If you are relatively new to the markets, you should be reading widely and often about the current market mechanisms and conditions. That means understanding the valuation basics, knowing which analysts and news sources to trust, and having an idea of the goals of your investment strategy.

It is important to understand whether we are in a rising or falling market. Equally, it is important to be aware of the general economic outlook and your current investment strategy (small amounts at regular intervals irrespective of price or a tactical large one-time investment). With these factors in hand, you will be well placed to avoid the pitfalls of break market rallies. This is unless, of course, you’re the storm-chaser type and on the lookout for them.

sp500 chart 2022
S&P 500 Chart  – 2021–2022 | Source: eToro

Lead with your head and not your heart

When investing, it is critical that you take a rational approach – conducting the proper due diligence on your own so that it aligns with your personal objectives. Outline a plan, execute and review why that went right or wrong. These are simple steps that could guide you to investment success.

Bear market rallies have one common trait – as mentioned above, they are symptomatic of herd-like behaviour as many rush to the short-selling exit or bargain-hunting entry point in unison. As the flow subsides, many may find few market participants left that are willing to take the other side of their trade anywhere near their entry point, resulting in a loss.

Rushes on a stock are inherently dangerous as flows often subside just as quickly as they rose, creating a swift reveal of something that Warren Buffet famously said, “You only find out who is swimming naked when the tide goes out” (source: Money.com). Sometimes it is arguably better to sit on the sidelines.

Implement sound risk management

Very rarely will everything come to you in one go. Only through many winning choices and actions will the balance go in your favour. In this regard, trading is an excellent analogy for life. By limiting your losses when the tide is against you, and taking healthy profits when the tide is rising, over and over, you will come out a winner in the end.

eToro has made a multitude of tools available to assist you in swinging the balance of probabilities in your favour over the long run. Familiarise yourself with stop and limit orders and only allocate a set percentage of your capital to each trade. That way, as you improve your decision-making and execution by studying regularly, you will be more likely to improve your performance during a bear market.

Review and understand

Cycling back to step one, once you have completed the life cycle of a trade, it is important to review your profits and losses on the trade to assess whether it was a winner or a loser.

Once you’ve assessed whether a trade is a winner or a loser, it is important to understand why. Was it good or bad timing on the execution? Did you miss a key market data release, such as a scheduled earnings announcement that you didn’t factor in? Sometimes unexpected things happen, but it is important to control everything you can so that you are not blindsided by a bear market again.

Final Thoughts

By now, you should have a better understanding of what a bear market and a bear market rally are. You should be aware of some of the pitfalls of a bear market rally and have thought some more about how you can identify and handle such market phenomena.

AskTraders has a wealth of quantitative and qualitative analysis to build your trading knowledge and confidence. Regardless of the state of the market – be it bull or bear – traders are advised to always conduct due diligence before making any investment.

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justin freeman
Justin is an active trader with more than 20-years of industry experience. He has worked at big banks and hedge funds including Citigroup, D. E. Shaw and Millennium Capital Management.