How to tell a bull from a bear market rally

Business Times - 09 May 2009

Typically, bear markets don't end in fear and panic, but on a feeling of despair and disillusionment, By TEH HOOI LING SENIOR CORRESPONDENT

HOW do we tell a bear rally from a genuine bull market? That's the question everybody wants answers to now. Well, William Hester, the senior financial analyst at the Hussman Funds in the US, tries to shed some light on the topic with his article Trading Volume Separates Bull Markets from Bear Rallies published last month.

Most market watchers know this: to confirm a change in market conditions, watch trading volume closely. In Mr Hester's charts, the blue dates represent the beginning of bull markets since 1940, and the red dates represent the bear rallies in this decade only. (I wonder why only bear rallies in this decade were included.)

In Chart 1, the vertical axis shows the S&P 500's decline in the month prior to hitting the trough. It attempts to capture how sharp the final move was to the low. The horizontal axis shows the bounce off the low in the following five weeks. It attempts to measure the intensity of the rally that followed.

Data that fall in the upper left portion of the graph represent periods where the market bottomed with little fanfare, and the rally that followed was similarly uninspiring. It would characterise a market where most participants had lost interest in the market. Data that fall to the bottom right represent periods where a sharp rally off the bottom approximated the severity of the preceding decline.

But as the clump of data points on the upper left portion of the graph suggested, most of the market bottoms are not characterised by the typical V-bottom capitulations that most investors have in mind. The bulk of bear markets have ended by falling less than 10 per cent in the final month - and were followed by similarly modest moves off the bottom. The exceptions were 1987 and 1998.

Meanwhile, bear-market rallies (those in red) have a more pronounced tendency to carve out an acute bottom - a capital 'V' to the typical bear-market bottom's lowercase 'v'.

The current rally sits far away from the blue data points, and shares its space with the five previous bear-market rallies, said Mr Hester. Yes, market does sometimes rally strongly at the beginning of a bull market, as happened in 1971, 1982 and 2003. 'But an important distinction is that the approach to their final lows was distinguished by a more moderate decline when compared with each bear market rally,' said Mr Hester.

The second characteristic of a trustworthy bear-market bottom is the accompaniment of a healthy increase in volume. In Chart 2, the vertical axis measures the S&P 500's five week bounce off the bottom, while the horizontal axis measures the change in New York Stock Exchange's trading volume. The two dotted lines group the data into three separate areas. Data points that fall in the upper left portion of the graph represent powerful rallies on contracting volume. Data points that fall in the lower right portion of the graph represent steadier advances with increasing volume or slightly contracting volume. The lower left portion represents bull-market bottoms that began with contracting volume.

From the chart, Mr Hester draws the conclusion that bear-market rallies tend to register strong (even if temporary) returns with contracting volume. 'And for the most part, the larger the contraction in volume, the more quickly the rally tended to lose steam,' he said.

Now, what does he make of the rally so far this year? Here are his comments: 'The characteristics of this year's rally are interesting. It's the strongest five-week rally over the entire data set - even with contracting volume. One positive we can note is that the volume is contracting on this rally less than it contracted in last year's bear-market advance. But the market has also run up strongly on volume that would be unusually weak for a bull market advance of this size.'

Most initial bull advances look like in those in the lower right part of Chart 2, he noted. Except for 1982 and to a lesser extent 1971 and 2003, bull markets tend not to be explosive in their first couple of weeks. And when they are, the moves tend to coincide with a similarly explosive increase in volume. NYSE volume grew by 40 per cent in the first five weeks or so of the 1982 bull market. At an S&P 500 dividend yield of nearly 7 per cent, stocks were cheap and investors showed their conviction. Prices are not that cheap today, he noted.

At the point of the report, in April 2009, Mr Hester noted that so far the rally in the US lacked that important quality. 'Over the next few weeks stock market volume will be a metric to watch closely.'

So what have the market activities told us in the past week? Here's the data. According to Bloomberg, the average daily trading volume of the stocks in S&P 500 up till Thursday this week is 23 per cent higher than the daily average last week. That definitely puts the current rally into the section of the graph that qualifies it as a bull rally. However, if we compare the average daily volume so far in May with that of April, the increase is just one per cent. So we will need to continue to see increasing trading volume before we can be sure if this is a bull rally.

Meanwhile, as for the Singapore market, the explosion in trading volume and price increase have - going by the criteria set out by Mr Hester - categorically puts us in a bull market.

The average daily trading volume on the Singapore Exchange so far this month is double that of the daily average in April. In terms of value of shares traded, it is three times last month's! The volume has been on an uptrend since March.

If trading activities are sustained for the rest of the month, then the number of shares traded will be more than three times the average in the nine months prior to March 2009. When the market turned in 2003, coincidentally also in May, the trading volume that month was 2.6 times the average in the previous nine months. Similarly, as the STI neared its peak in 2007, trading volume in July 2007 was 2.4 times that of the average in the previous nine months. The value of shares traded was 1.8 times that of the previous nine months.

Hence on the market activities front, there are increasing signs that we have indeed formed a bottom. As Mr Hester noted, bear markets don't typically end in a crescendo of fear and panic, but more often on a feeling of 'despair and disillusionment', while strong bull markets tend to feature heavy trading volume. Indeed, around March this year, there were a lot of disillusioned investors out there.