Bear Market Rallies – Part 2

07/03/2008 12:00 am EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

In Part One, I reviewed some of the past bear market rallies and concluded with the analysis of the Dow Industrials as of early June 2008. The goal of this series is to reinforce some of the common characteristics of bear market rallies in the hope that the reader will be less likely to be fooled by them in the future. In Part Two, I would like to share additional examples of bear markets in major averages and look at how some individual stocks behave during bear market rallies.

Table 1
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One characteristic of bear markets is that in the majority of cases the strongest sector of the market will correct the most and the weakest sector will top out last and decline the least. The table above looks at the Dow Industrials, S&P 500, and NASDAQ Composite during the period from the 1998 lows through the 2000 highs and then back to the 2002 lows. From the table, you will note that the Dow gained 61% from the 1998 lows to the 2000 highs and was weaker than the S&P 500 (68%) and much weaker than the NASDAQ Composite (278%). The last column reflects the extent of the bear market as the NASDAQ declined 78% from the highs while the Dow Industrials only suffered a drop of 40% and the S&P 500 lost 50%.

Figure 1
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In Part One, we looked at the top in the NASDAQ Composite in 2000 and the initial bear market rally that occurred from May to September of 2000. For comparison purposes let’s look at the Dow Industrials where the pattern was much different. While the NASDAQ was crashing, the Dow held up much better as it rallied up to a high of 11,350 in May of 2001 before decisively breaking support going into the September lows of 8062. The rebound lasted six months and had a similar structure to that of other bear market rallies that have been examined. It was impressive as the Dow gained 32% from the lows at 8062 before topping out. The rally exceeded the 61.8% resistance (at 10,500) from the all time highs, but fell short of the 78.6% resistance at 11,157. The uptrend in the RSI (line B) was broken on April 12th (point 1), two weeks before the corresponding price support (line A) was broken. The sharp short-covering rally three weeks later took the Dow up over 400 points for the week, but the RSI just rallied slightly above its declining WMA (point 2). This was a low risk selling opportunity as the RSI formation made the chances of a new rally high very small and, as it turned out, the RSI reversed the next week. Over the next eleven weeks the Dow plunged and finally stabilized just above 7500. Using the rally from the September 2001 lows to the March 2002 highs, the 127.2% Fibonacci downside projection was at 7377 and the low in October 2002 was at 7197. Though not identified on the chart, the RSI did form a positive divergence at the October lows.

Figure 2
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Before moving on to individual stocks I want to look at another period for the Nikkei 225. Last time we looked at the bear market rally that terminated in July 1990 at 33,334 (point 1). The market declined sharply for the next few months, eventually reaching a low of 19,781 (point 2) the week of October 25, 1990. The short-term positive divergence in the RSI (line b) suggested a rally, which ended up lasting until March of 1991. The rally peaked at 27,272 (point 3) just barely exceeding the 50% resistance level at 26,637 but failing to surpass the 61.8% level at 29,305. As the decline resumed into the summer of 1991, it bottomed at 21,309 (point 4) and held above the prior lows. I included this low as it illustrates how sharp rallies can be within an overall downtrends but still not change the major trend. From the lows at point 4, the NK225 rallied up to 25,254, a gain of 3945 points or 18.6% in just nine weeks. At the time, many thought the bear market was over; however, the NK225 stalled at 61.8% retracement resistance (calculated using points 3 and 4) and fell well short of the 78.6% resistance at 26,150. The rebound ended in early November and the market plunged for the next six weeks, reaffirming the downtrend. The 161.8% price projection (based on the rally from points 2 to 3) was at 15,412 and the NK225 reached a low of 14,194 in April of 1992 (point 6). Though not labeled on the chart, the 261.8% projection target (using the rally from 4 to 5) came in at the same level. The RSI made its low in April and subsequently formed two positive divergences (line c), so a decent rally should have been expected. In fact, the NK225 traced out a flag formation over the next three years but never exceeded the 61.8% retracement resistance of the decline from point 3 to point 6, which came in at 22,314. The uptrend in the RSI (line c) was not broken until the middle of September 1993, confirming the multiple negative divergences (line d) that forecast another 3700 point decline.

Figure 3
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As illustrated by the table early in the article, the NASDAQ was clearly the strongest major average from 1998 to 2000, and Cisco Systems, Inc. (CSCO) was one of the strongest stocks in the NASDAQ. From the 1998 low of around $10 it peaked in March 2000 at $80 (point 2). The weekly RSI did form a negative divergence at the highs, point 2, and the broke support (line a) the next month. CSCO did rebound from the lows at $50 (point 3) but on the rebound the RSI was barely able to make it above its declining WMA and stalled below 55. This was a sign of weakness. The oversold rally lasted 14 weeks but stalled at the 61.8% retracement resistance that stood at $70. The break of short-term support in the $62 area put the bears back in charge as CSCO plunged for the next seven months. The first downside target, projected using the 3 to 4 rally, was at $38.50 (161.8%) and it was reached before the end of 2000. The 261.8% price target was exceeded in April of the next year as the stock dropped to $13.18 before turning higher. The RSI did not form any divergences at the lows but did rally back above its WMA.

Figure 4
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Another well-known stock from the tech boom was Oracle Systems (ORCL). It should be noted that I selected both CSCO and ORCL because they were the first that came to mind, not because I knew them to fit key aspects of bear market behavior. As it turned out both did. The weekly chart of ORCL is equally dramatic as it rose from a 1998 low of $3.30 to a 2000 high of $46.46. The RSI peaked in late 1999, forming the first negative divergence at the March highs (point 2). The uptrend in the RSI (line a) had already been broken, and in March, the RSI had rallied back to its former uptrend. ORCL dropped below $30 on the decline in the overall market but then, unlike the NASDAQ, made a marginal new high in September 2000 ($46.46 versus $45.00). Five weeks after the highs (point 3) the price support (line b) was broken and the RSI, which had formed a much lower low, (point 3) was already in a well-defined downtrend. The break of price support in the $30 area further confirmed the highs and one could make a case for a double top formation (points 2 & 3). ORCL bottomed just above $22 in November (point 4) and then started a bear market rally. The seven-week rebound reached the $35 area, a 60% rebound from the lows, and slightly exceeded the 50% resistance. The rally fell well short of the 61.8% resistance at $37.35. After closing on the highs (point 5), ORCL reversed to the downside the next week and dropped sharply to the $13 level. This was the 161.8% target calculated from the rally from point 4 to 5 and also the target from the double top formation on the weekly chart.

Figure 5
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Those of you who have used the RSI realize that the signals are not always as clear as they were with CSCO and ORCL. A good example of this in 2000 to 2002 was Amazon.com. The weekly chart shows that AMZN spiked to new highs in both January (point 1) and April (point 2) of 1999 before pulling back to important support in the $40-$42 area (line c). The RSI formed a negative divergence in April (point 2), and as AMZN was bottoming in the summer of 1999, the RSI showed a pattern of lower highs and lower lows (lines a and b). AMZN was able to make another new high at $113 in December but the RSI formed another lower peak (point 3). It is interesting to note that the RSI did break its weekly downtrend (line b) at point 3, but failed by a small margin to exceed the prior high. Clearly this could have been a bit harder to analyze. The fact that the RSI had failed to reach oversold levels and had not formed any positive divergences should have kept the bulls cautious. Three weeks later, the picture had become clearer (line e), as the RSI dropped back below both its WMA and the short-term uptrend. Price support (line d) was violated the following week. Four weeks later, AMZN had a sharp one-week rally that failed at the 50% retracement resistance, and the downtrend resumed the following week.

Figure 6
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Network Equipment Technology (NWK) was one of the star performers of 2007 as it rose from a low of $7.10 in March to a high of $15.75 on October 11, 2007. The weekly chart on the left shows a ten-month negative divergence in the RSI (line a) as the RSI peaked in February (point 1) and then formed a much lower high in October (point 2). The week NWK made it’s high and it closed lower for the week, which was a sign of potential weakness (point 2). Just three weeks later, the weekly RSI dropped below its WMA, and seven weeks after making its high of $15.75, NWK had dropped to a low of $10.92. This was a decline of 30.6%. There were some useful signals on the daily chart, which is on the right. For example, the daily RSI dropped below its WMA and the uptrend (line d) two days after NWK made its highs. The sharpness of the decline and the long-term divergence in the RSI suggested that this was more than just a correction. As is typical of bear market rallies, NWK rallied over 20% from the November 26th lows just barely exceeding the 50% resistance at $13.35 and falling short of the 61.8% level at $13.91. This type of rally gives hope to those who are still long and the sharpness of the rally scares many who are considering the short side. The RSI on both a weekly and daily level suggested this would be a failing rally as the weekly RSI failed to even reach its declining WMA while the daily just bounced to the resistance at the 55 area before reversing. The downside projections from this rally came in first at $9.32 (161.8%) and then at $6.75 (261.8%) which were both met over the next month. As of early June, the low in NWK so far has been $3.95.

The objective of this two part series was to demonstrate some of the common characteristics of bear markets and bear market rallies. The evidence as of early June 2008 suggests that the rally from the March 2008 lows to the May highs was a bear market rally. From a sentiment viewpoint, bear market rallies generally last longer than the majority expect and often exceed the 50% retracement level and occasionally even the 61.8% resistance. Stops above the 78.6% level should generally be used. Longer-term technical studies such as the RSI can be monitored, as after completing weekly top formations the indicators will often just rebound to resistance or their moving averages. For example, the MACD-Histogram may make it barely into positive territory, but is likely to reverse the following week and then move back below the zero level. The daily indicators should be watched closely as once multiple negative divergences are evident the rally is likely over. The Fibonacci projection analysis can then be used to determine downside targets. I use three main ones, 127.2%, 181.8%, and 261.8%, as once the 127.2% target is reached I will cover 1/4 to 1/3 of the position, thereby reducing my exposure. The same series of steps should be used on individual stocks, and it’s important to recognize that many will follow the pattern of the major indices while others will not. Therefore, some may top out either before or after the major averages. Hopefully, you will find this helpful in your analysis and trading.

Editor’s Note: Since Part One was released, the key Dow support levels noted at that time, 11,900 and 11,630, have both been broken. Therefore, I put together the table below, which gives some of the downside Fibonacci targets for the major averages. Please note that the 2008 low for the Dow was in January while the March lows were used for the S&P 500 and the NASDAQ.

Table 2
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.As always I welcome your feed back on these articles and I can be contacted at tomaspray@intershow.com. I would also appreciate any suggestions you may have for future articles.

Tom Aspray, professional trader and analyst, serves as video content editor for InterShow's MoneyShow.com Video Network. Mr. Aspray joined InterShow full time in June of 2007 where he also does other editorial work for the site, including the bi-weekly trading lessons and the weekly charts to watch. Mr. Aspray has written widely on technical analysis and has given over 60 presentations around the world. Over the years, he has applied his methodologies not only to the stock and commodity markets but also the global markets, mutual funds, and foreign exchange. Many of the technical indicators that Mr. Aspray wrote about in the 1980s, such as the MACD, have since gained worldwide acceptance. He was originally trained as a biochemist but began using his computer expertise to analyze the financial markets in the early 80s. As a consultant, Mr. Aspray wrote daily institutional reports for firms such as Fleming Jardine and Barings Bank and was noted by the Wall Street Journal as one of the "top bond market technicians."

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