Finding a rally in bearish times

Though desperately desired, some stock-market surges may be 'fake-out breakouts'

How far can a bear run uphill? The stock market has roared higher from its March lows. Now up more than 15 percent in just a few weeks, it has many investors hoping for a sustainable rally - even the onset of a new bull market.

While few professionals are comfortable predicting the start of a new bull, some anticipate that the market could continue to move higher in the coming months.

Many major sectors of the market could move 20 percent higher by year end, according to Ralph Acampora, managing director of global equity research at Prudential Financial.

Others, however, question the rally's durability.

Investors should guard against buying into a "fake-out breakout," says Bernie Schaeffer, of Schaeffer's Investment Research. The decline in the dollar will undermine the market's ability to move significantly higher, he says.

In addition, Mr. Schaeffer notes a high level of bullish sentiment on the part of investors - itself a bearish indicator to market contrarians.

So-called "sentiment indicators" showing very high levels of bullishness or bearishness often imply the opposite for market action, Schaeffer and other experts say. For example, the highest levels of bearishness tend to occur at market bottoms. Right now, the level of optimism is rather high, Schaeffer says, a phenomenon that correlates with a market top.

Often, sharp rallies occur during bear markets, says John Mauldin, who writes "Thoughts from the Frontline," an investor newsletter. He believes that the US market is only three years into a long-term bear.

For a sense of how long, Mr. Mauldin points to precedents: There have been seven long-term bull markets and seven long-term bears since 1800, according to his research, with the average long-term bear market lasting 14 years.

Still Mauldin notes that, historically, fully half the years of a long-term bear market show gains for the year. In addition - as the chart below indicates - rallies provided significant opportunities for substantial short-term percentage gains even during the worst bear market in US history. (Rallies on the chart indicate gains ranging from 11 percent to 39 percent.)

In order to benefit from the rallies, however, investors had to take profits near the end of each rally. Buy-and-hold investors suffered dramatic losses during the overall decline.

And while market indices eventually recovered to their prior highs (after 25 years in 1954), many individual stocks never recovered.

In addition, inflation took a heavy toll on the purchasing power of investors as well. Breaking even after inflation took roughly another 30 years.

What can investors do when confronted with the prospect of occasional, but significant, rallies within the context of what may be a long-term bear market?

It's not necessarily all about jumping in and out of stocks, experts say.

Sir John Templeton, one of the greatest long-term investors, told CNBC last year that he believed the bear market would run for some time and that he had placed a significant portion of his money in market-neutral funds, which were 50 percent long and 50 percent short.

Other investors might look for funds that have shown an ability to make money in both up and down markets.

Morningstar.com, the site run by the mutual-fund tracker in Chicago, shows that the Gabelli ABC fund, a fund focusing on merger arbitrage, has been profitable each of the past seven years.

Some bond funds have also been consistently profitable. Experts warn, however, that buying bond funds when interest rates are near 40 year lows might expose investors to substantial risks. When rates rise, bond prices usually fall.

Interestingly, economic growth may not provide the surest gauge for stock-market improvement.

Mauldin points out that from the end of 1930 to 1950, the economy doubled, but stock prices essentially remained the same.

Investors who wish to vary their exposure to the market to try to benefit from the rallies and avoid the declines may also need to learn to judge the quality of a rally.

This current surge is suspect, says Terry Bedford, hedge-fund manager and president of Bedford and Associates Research Group. He cites evidence including the relatively low volume of trading behind much of the rally.

He notes that strong rallying by the worst-quality companies generally indicates active "short covering" - a protective tactic that traders use - rather than new buying by long-term bullish investors.

"Even a turkey can fly in a strong enough wind," says Mr. Bedford.

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