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The Making of a New Bull Market: Themes for Traders and Investors

The Making of a New Bull Market Tips for Traders and Investors


I've professionally lived through 8 bear markets including 1981, 1984, 1987, 1990, 1994, 1997 (brief but scary), 2000-2002, and 2007-today, so I have a bit of history here. Each of these bear markets was different, but each has had basically the same characteristics when they rallied and transitioned into bull markets. I want to share with you what these characteristics have been and how they can guide you if in fact this market really is transitioning back into a bull market. Not only will you be able to use these guidelines now, you'll likely be able to use them for years to come.

Here are the 8 common themes:

1. There is no rational economic reason for the early rally.

2. The semi's lead first.

3. Every bear to bull transition is accompanied by the financials. If the financials don't rally, there is no bull market.

4. Basic materials usually lead too. If there is no building, there is no recovery.

5. The market pounces on any good news and shrugs off (ignores) bad news.

6. The market will gap lower and then close higher for the day. It will do this over and over again.

7. The last hour of trading is often accompanied by strong buying. This buying is usually caused by large money on the sidelines combined with panic short covering.

8. The U.S. market leads the other world markets higher. It always has and until proven otherwise, it will again this time.

If some of these themes look familiar to you now, it should because this is what the last few weeks have looked like. But until the market breaks above the 200-day moving average, I still define the market as being in a bear market and I'll trade it that way (it's the prudent, statistically proven thing to do as we've seen over the past 15 months). This bear market will eventually end, though, and as many of you who have been trading for many years know, there are few things prettier in the business world than a new bull market.

Now let's take a closer look at each one of these themes:

1. There is no rational economic reason for the rally.

Go to this website and you'll see this in action. This is from late last week titled "What the Hell Just Happened On Wall Street". Read the comments. Disbelief! How could the market rally over 20% on a few weeks with such dire economic news on the forefront? Just how stupid is the market???

The market isn't stupid. It does what it does. 20% ago it had factored in the worst. When the worst didn't occur it rallied higher. And if things even remotely improve, it will rally further.

Look at every rally off the bottoms for the past 3 decades. They were all led by journalists and analysts who were in denial. The lesson to be learned here is early in a bear market to bull market transition, there will be little if any economic reason to support it.

2. The semi's lead first.

Usually by a few months. They're usually the first sign of economic activity. Look at 2003 as the best example. SMH (SMH | Quote | Chart | News | PowerRating) rallied a few months ahead of the overall bottom which led to a four year rally.

3. Every bear to bull transition is accompanied by the financials.

If the financials don't rally, there is no bull market. And this time it's obvious why. Money and credit make the business world hum. No money or credit and we get a major recession like now. Money and credit starts flowing again, the economy starts flowing. Watch XLF (XLF | Quote | Chart | News | PowerRating). It's the financial ETF made up of banks, insurance companies, and real estate. As it goes, the market goes.

4. Basic materials usually lead also.

If they're not building, there is no recovery. This factor is not as powerful as the semi's and the financials, but it needs to be watched. If basic material stocks are moving, it means products are being built. In a recession, few are building unless there is demand and orders. I watch UYM (UYM | Quote | Chart | News | PowerRating) (the 2x Materials). It does a good job along with the semi's and banks telling us the upcoming state of the economy.

Keep SMH (SMH | Quote | Chart | News | PowerRating), XLF (XLF | Quote | Chart | News | PowerRating) and UYM (UYM | Quote | Chart | News | PowerRating) in front of you to watch the health of the markets. And understand that the stock market action in these three industries speaks louder than journalists and analysts who are struggling to make sense of "What the Hell Just Happened?"

5. The market pounces on any good news and shrugs off (ignores) bad news.

In bear markets, bad news gets pounded on. We saw that throughout 2008. But in markets that are transitioning into a bull market, the bad news is often met with the opposite reaction. The market often shrugs it off and then proceeds to rally.

Think about all the negative news throughout the last three weeks of March. High unemployment, the very high risk of bank failures (do you remember Citi at 1.02?), higher likelihood of defaults, and more. Yet, what did the market do? It staged one of its largest 3-week rallies in 7 decades. It shrugged off the bad news and the slightest bit of news that was not as bad as expected (it wasn't good news, it was simply not as bad as expected) was met with days of massive rallies. When you see this occur over and over again, it's a good sign that the selling at least for the time being is done and they're looking for any reason to rally the market. Remember the proverbial phrase "if it doesn't go down on bad news, it's very likely going higher."

6. The market will open weak and then close higher for the day and do this over and over again.

Sick markets open strong and end weak. Healthy markets open weak and end strong. In bear markets that are transitioning to bull markets, the markets will open poorly, often tied to negative news as mentioned above, and then reverse and end higher. The day's close will often be higher than the day's open. If you look at any of the 7 previous bear markets over the past three decades, they all did the same as they moved to a bull market. They opened weaker as they had been doing for many months and all of a sudden they started closing higher. And they did this over and over again. This frustrates the hell out of the shorts and it also panics the big money on the sideline into getting money invested as quickly as possible. When you see this happening over and over again, it's a good sign that the bear market is getting close to an end.

7. The last hour of trading is often accompanied by strong buying. This buying is usually caused by large money on the sidelines combined with panic short covering.

In bear markets the last hour can be brutal. Think about the many days in October 2008 and again in February and very early March 2009, Much of the daily declines occurred in the last hour and especially in the last half hour. When markets are transitioning to bull markets, just the opposite is true. The last hour is often moving higher and often it's very strong. As I've mentioned, this buying comes from panic short covering and also from money managers who need to put money to work (they've been in cash, a safe haven for them, and now they run the risk of underperforming unless they get that cash invested). You can really get a good idea of longer term sentiment from that last hour because it's fairly consistent. In bear markets, it's often down sharply. In markets that are transitioning to a bull market, it's often significantly stronger.

8. The U.S. market leads the other world markets higher. It always has and until proven otherwise, it will again this time.

In the late 80s and early 90s Japan was supposedly going to conquer the world. They were buying up everything they could and there was a fear that much of the United States was going to be owned by them. Over the past few years this type of psychology was again seen when discussing the major oil countries, and the BRICs, especially China. In fact, one of the big early overnight market declines in 2007 occurred because China had a large one-day drop. Yes, many countries are all tied together more closely than ever before. But, as we saw again over the past 18 months, the U.S. still leads the worlds markets both up and down. This may change someday and the arguments for China are compelling (as compelling as they were for Japan two decades ago), but as we look at the state of the world markets and the world economy today, as the U.S. goes, so goes most of the rest of the world.

As the world markets transition to bull markets, the U.S. will lead the charge, just as it's done from early March through early April. The U.S. is up 20% from its bottom and most of the other major indices are up because the U.S. has led the way. This has been the story for decades and until proven otherwise, it will be the story for this market too.

The single best simple rule to truly guide you through bull and bear markets.

In 2003, we wrote a report which quantified how the market and stocks perform better when they are above the 200-day moving average than when they are below. This study was further updated in my book (co-authored with Cesar Alvarez), Short Term Trading Strategies That Work. When this research was originally published 5 years ago, we quantified the behavior above and below the 200-day moving average and showed statistically, using a sample size of over 8 million trades, that it was better to be buying stocks with the market above the 200-day than below. Little did we realize then that this one rule would be the single best determinant for the future direction of stocks as the bear market starting hitting in early 2008. Many banks and brokerage stocks started breaking under their 200-day moving average in 2007 (an early warning, remember the financials lead) and eventually many dropped 70% or more in value, with some losing almost 100%. This one rule alone could have saved money managers and investors many billions of dollars of losses had they simply avoided the "cheap stocks" under the 200-day average.

This year, as many of you have seen in the Daily Battle Plan, simply focusing on ETFs that are overbought below their 200-day on the short side has allowed the Model Portfolio to be successful with the 12 of the 13 ETF signals which have triggered. The reason for this is that the market, in spite of the many signs that it is transitioning to a bull market, is still in a bear market. And I'll define it as a bear market until it gets above the 200-day moving average (and many markets are getting closer).

I realize that eventually the market will race to the 200-day moving average as it transitions and we'll be short. But using this approach, we'll gladly give a small piece of the gains back because of the accumulated short side profits that have occurred for those shorting under the 200-day since early 2008. Plus, I know many people who used the 200-day simply to go into cash. And when most money managers are down 35-40% in the past 15 months, it will likely take years for them to make these losses back. Those who used the 200-day and went into cash, have most of their original money still in place (and some are even up for the past two years) and they can continue to grow their money from here.

The 200-day rule is a good rule and one that has been good to many people for a number of years.

This wraps up my series on how to identify when a bear market is transitioning to a bull market. I don't have the crystal ball to know when the next bull market is. But market behavior often repeats itself and the 9 rules above have repeated themselves for 7 consecutive bear markets since 1981. It's a good track record and a track record that's worth following for years to come.