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Beware of This Deceptive Bear-Market Trait

There’s only one rule which applies to a 2nd wave rally…

by Bob Stokes
Updated: August 25, 2022

Big stock market trends don't progress up or down in a straight line. In a bear market, stocks typically rebound after the first leg down. In a bull market, the opposite happens: Stocks again take a big dive, making everyone think the bear market has returned.

But in a bear market, that "first leg down" is wave 1 and the partial "rebound" which follows is wave 2. I say "partial" because the only rule which applies to wave 2 is that it cannot retrace 100% of wave 1. Meaning, the bear market rally cannot go above the previous market top.

That said, the percentage of these retracements can be quite high. Let's look at a couple of historical Dow Industrials' examples, starting with 1968-69:

1968-69

As you can see, the wave 2 rebound retraced 80% of the wave 1 decline. The last thing many investors expected was the portfolio-crushing wave 3 which followed.

This next chart shows that the percentage of the wave 2 retracement during the 1937-38 bear market was even higher:

1937

Following wave 2, wave 3 brought a 41% decline in just three months. Parenthetically, by the time wave 5 was complete, the Dow Industrials had dropped 49% from the wave 2 high.

Be aware that a key characteristic of wave 2 during a bear market is that the bullish psychology is usually just as intense -- or even more so -- than what was displayed at the top of the prior bull market. Many investors believe the first drop in the bear market created "bargains" and scoop them up.

Is the same pattern of investor psychology playing out here in 2022? Here are some recent headlines:

  • Bank of America, Disney, and Uber All Look Like Bargains (Barron's, August 8)
  • [Managing Director] makes his case for S&P to reach 4,800 by year end (CNBC, August 5)
  • Investors Spot Bargains Among Small-Cap Stocks (Wall Street Journal, June 1)

The bullish sentiment expressed in these headlines might turn out to be correct.

On the other hand, we do know that the U.S. stock market top occurred in January, and after an initial leg down, the market staged a significant rebound.

If a devastating wave 3 down is next, the remainder of the bear market may be far more devastating than what was shown in the two historical examples.

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