Was the October 4, 2011 rally a bear market rally? That's one of the big questions being asked today.
According to Investopedia, a bear market rally is usually a short-lived market increase following a period of market decline and is followed by another period of market decline leading to a pronounced down-trend.
Oftentimes, a bear market rally can be confused for the bottoming out of the bear market. But this is dangerous. After the peak of the bear market rally is reached, the decline is often so swift that investors are lucky to exit the market at a price higher than their buy-in.
Therefore it's important for investors to find out if they are in the midst of a real rally, or simply a bear market rally -- a task easier said than done.
James Kostohryz wrote on Seeking Alpha three handy tools for investors to identify the characteristics of a bear market rally so as not to be lured into one.
Recognize a bear market rally
1. Fundamentals: The first challenge in determining if a rally is legitimate or not is to address the fundamentals of the bear market. Are they still in play? "Stocks will often rally on relatively insignificant news during a bear market rally -- news that in no way negate causes of the original decline. However, in a bear market rally, fundamental deterioration continues beneath the surface despite rising stock prices."
Given that troubles in Europe helped spark the market decline, we can say these fears still hold. In fact, the likelihood of an economic collapse in Europe seems more likely today than it did on October 4th. The same can be said of America's political and budget-cutting issues.
2. Low Volume Advances: "Bear market rallies are characterized by extremely sharp advances on relatively low volume. Such advances are driven by price-indifferent purchases by short-sellers, put buyers, and call sellers that are aggressively executing stop-loss orders," writes Kostohryz. "Furthermore, in bear market rallies the sharpness of the price increases indicate price indifference on the part of long investors."
With regard to this element, market actions since October 4th have been sharp and on low volume.
3. Sentiment: Rallies are fueled by a reversal of pessimism and skepticism, explains Kostohryz. "Extremely bullish sentiment suggests a high probability that reasonably foreseeable positive factors are already almost entirely discounted in the price of stocks."
He argues since October 4th, the bullish sentiment has increased sharply, and bearishness hasdecreased sharply, but investors are still defensive in their positions. However, they appear to be less defensive than they were on October 4th -- "This suggests that if good news were for whatever reason forthcoming, the stock market could rally significantly -- indeed potentially beyond the May 2nd highs."
He says that the sentiment is not contingent with a bear market rally, and more so with a recovery, or at least significant upside potential in the recovery.
Two out of three bear market indicators, as outlined by Kostohryz, suggest we are in the midst of a bear market rally. So, if we are indeed in a bear market rally, which rallies are expected to reverse?
For ideas, we started with a universe of about 200 stocks in rally mode, i.e. trading above their 20-day, 50-day and 200-day moving averages.
We then collected data on short-seller trends and identified a list of names that are being targeted by short-sellers.
In addition, all of these companies have seen significant institutional selling during the current quarter.
Sophisticated investors, like short-sellers and hedge funds, think these rallies are about to reverse. If we are indeed in a bear market rally, would you short these names?
List sorted by the distance from the 200-day simple moving average (SMA). (Click here to access free, interactive tools to analyze these ideas.)
List compiled by Eben Esterhuizen, CFA:
1. Barnes & Noble
4. FEI Co.
Interactive Chart: Press Play to compare changes in analyst ratings over the last two years for the stocks mentioned above. Analyst ratings sourced from Zacks Investment Research.
Kapitall's Eben Esterhuizen and Rebecca Lipman do not own any of the shares mentioned above. Short data sourced from Yahoo! Finance.
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