Is it really a bear market rally?

 

Equity rally or momentary risk-on phase?

In just a few weeks, equity markets have recouped half of their 2022 losses. This rapid rally raises the question: are we in a bull market or is this just an interim episode (what market watchers call a bear market rally)? The latter is the term used to describe a “risk on” phase – when investors mistakenly take on equity and credit risk – during the middle of a longer bear market period.

Such a scenario is often a trap, many investors will remember rallies in February / March 2002, March / April 2008 and more recently December 2015 and November 2018. These rallies are particularly insidious for the dynamic manager, who can easily find themself caught off guard by hopes of a rebound only to then find themself caught up in a painful capitulation.

The big question is therefore whether are we currently in a bear market rally? Here is our perspective.

 

Analysing past regimes

Slicing through a century of S&P 500 Index returns to analyse the past bull and bear markets, as well as the even more complex bear market rallies, is an arduous exercise. It would be an impossible quest without econometric tools – that much is certain; but can financial econometrics really help us accomplish such a task?

That challenge was taken on by Maheu, McCurdy and Song in 2012. Their research article¹ proposed an econometric model (Markov Switching) with a constrained structure that made it possible to identify bull and bear market regimes, as well as the sub-regimes within them, such as:

• A bull market correction (BMC), which marks periods of profit taking leading to a temporary decline in the markets within a bull cycle
• A bear market rally (BMR), which marks periods of financial market recovery within a longer bear market period and is the focus of this insight

The beauty of their approach is that they proposed a structural model of market behaviour and calibrated this over a century of data. Their key conclusions were as follows:

• BMR periods can last up to half a year
• The performance of BMR periods is generally comparable to the performance of bull market periods, making them difficult to distinguish
• BMR periods are nevertheless more volatile than bull market periods: this is how we can differentiate them
• Finally, BMRs lead to a return to either a bear market or a bull market period: the probability of transitioning to either one of these regimes is estimated by the authors as being relatively close

To apply their conclusions to the current context, not only does the average investor have to identify whether the current period is a bear market rally or a bull market period; but in the case of a bear market rally, it also must be determined whether it is the end of the bear period or a transitional phase before a new decline.

 

Today’s context

We have undertaken the arduous exercise of replicating their analysis and bringing it up to date by extending the data with the missing decade. Overall, we concur with most of the conclusions of the original article as well finding some additional elements that may be of interest:

• The current period is almost certainly a BMR period, as the model shows that this regime has experienced higher performance than a typical bull regime but with higher volatility. At the time of writing, the probability of being in such a regime is calculated to be 86% (as shown in figure 1)
• We have identified a total of 433 bear market rallies between 1926 and 2022.  On average, we found that these periods are shorter than those shown in the paper, and 57% of these lasted for just one week. The number of episodes exceeding 5 weeks was 11 (see chart 3) which suggest the current episode is truly extraordinary
• After 4 weeks, the average performance of the S&P 500 is positive, but the number of these cases is too small to give much credit to this statistic
• Finally, the longest BMR period took place in October / November 1935 (7 weeks) and eventually led to a bull market. Given the frequency of these regimes, it should be a matter of days before we see a clearer direction for the markets, as these periods rarely exceed two months according to this analysis

To put it simply, this current bear market rally period should come to a rapid end and will then take on a more definite and, above all, sustainable upward or downward direction.

 

Figure 1. Conditional probability of each scheme in 2022

Source: Bloomberg, LOIM. Note: Bull market represents the merging of “bull” and “bull market correction” episodes in order to make the reading of the chart easier. Past performance is not a reliable indicator of future returns.

 

Figure 2. Probability of regime transition when in a BMR (1926-2022)

Source: Bloomberg, LOIM. Past performance is not a reliable indicator of future returns.

Figure 3. Distribution of BMR episodes by duration in weeks (1926-2022)

 

Source: Bloomberg, LOIM. Past performance is not a reliable indicator of future returns.

 

Sources

[1]  Maheu, John M., Thomas H. McCurdy, and Yong Song. "Components of bull and bear markets: bull corrections and bear rallies." Journal of Business & Economic Statistics 30.3 (2012): 391-403.

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Macro/Nowcasting Corner

The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. Along with it, we wrap up the macro news of the week.

Macro news flow has continued to deteriorate this week. Starting with the US, we have witnessed a consistent deterioration across leading surveys and housing data. The Empire survey not only declined in July (from 11 to -31) but fell short of expectations (5) to reach levels consistent with the entry point of a recession. The Leading Index is also consistent with such a level, published at -0.4 vs. -0.5 expected and -0.8 the month before. Retail sales did not progress last month, after a +1% growth the month before. On the housing side, housing starts declined by 9.6% versus -2.1% expected and -2.0% the month before. The National Association of Home Builders index also declined from 55 to 49, against an expectation of 54: here, there are only traces of a growth slowdown. The only positive datapoint was the capacity utilisation rate which rose from 80% to 80.3%, beating expectations. The US economy is slowing down and data this week has acted as a major source of confirmation. The Federal Reserve (Fed) minutes also showed how the Fed’s fight against inflation is not over yet: another slowdown factor to consider over the coming months.

For the Eurozone, the key data point has been the publication of the GDP numbers for Q2: the Eurozone has been growing by 0.6% versus 0.7% expected. Not a bad number, especially when compared to the rest of the G10 economies: the Eurozone is not in a recession just yet.

The Chinese economy has been a major source of disappointment for economists this week: its industrial production and retail sales are not growing as fast as economists expected, notably leading the People’s Bank of China surprising markets by moving current benchmark rates by 10 bps (from 2.85% to 2.75%),.

Our nowcasting indicators currently point to:

• Worldwide growth is clearly declining. The US and Eurozone are showing signs of decelerating growth momentum.
• Inflation surprises will remain positive for the Eurozone but are declining elsewhere and are now non-existent in the US.
• Monetary policy is set to remain on the hawkish side: central bankers are likely to be more hawkish than expected.

 

World Growth Nowcaster: Long-Term (left) and Recent Evolution (right)

 

World Inflation Nowcaster: Long-Term (left) and Recent Evolution (right)

 

World Monetary Policy Nowcaster: Long-Term (left) and Recent Evolution (right)

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy). For illustrative purposes only