Bullish rushes of exuberance are common during bear markets - and it's very easy to get caught up in them

Bullish rushes of exuberance are common during bear markets – and it’s very easy to get caught up in them

Just because it looks like a bull market doesn’t mean it is a bull market. It is important to note how bullish investors have become in the wake of the US market’s two-month rally away from its June lows. Many have announced that a new bull market has begun.

They may be right. But know that bursts of investor enthusiasm happen frequently during bear markets. This tendency to prematurely announce the end of a bear market is poorly understood, as many believe that investors’ mood gradually declines during a bear market in a somewhat straight line. If the investor consensus follows this path, the average investor will be more bullish at the beginning of a bear market and more bearish at the end of it.

Read: An economist predicts a ‘massive’ recession in 2023 – not necessarily due to higher interest rates

This is not usually the case. Instead, during bear markets, investors usually experience many episodes of mania and depression, oscillating between desperation and exuberance. They are often more optimistic near the end of a bear market, rather than the beginning, and when their belated bear market enthusiasm wanes, they are throwing in the towel for good.

A good example of this advance in bear market sentiment is what happened during the 2007-2009 bear market. Take a look at the chart below, which reflects the average level of capital exposure among the 500+ typical portfolios tracked by Hulbert Financial Digest.

Note carefully that the average plotted in the chart is not the same as any of the stock market sentiment indicators calculated by my company, which reflect the average level of exposure among subsets of short-term market timers. In contrast, the graph plots the average exposure level among all monitored newsletters, including those that say they are not market timers. Interestingly, many of these buyers and holders are temporary in the market, and their levels of exposure to their stocks vary over time.

Note the pattern of higher highs and lower lows: Each of the several episodes of manic bear market in 2007-2009 was marked by a higher average bullishness than the previous one, just as each episode of depression showed more desperation than the previous one. As a result, the highest level of the uptrend during the 2007-2009 bear market occurred just before the most recent decline.

This higher level of climb occurred in January 2009, three months after the collapse of Lehman Brothers brought the global financial system to its knees, and six weeks after the Central Bank of Oman’s Volatility Index, or VIX,
-0.04%And the
He hit a previously unimaginable high at the next 90. Certainly, the advisors said to themselves, the worst was behind them. However, the recent bottom of the bear market was still two months away.

This tendency to be bullish before the end of a bear market is a reflection of the psychological pattern behind the classic saying “it’s darker before dawn”. In the case of bear market sentiment, one could say “things look brighter before they get darker.”

Read: The stock market usually drops to bottoms before the end of the Fed’s rate raising cycle. Here’s how to make that bet pay off.

This helps explain why bear markets usually end with a so-called capitulation – a convulsion of that deep desperation with which investors throw in the towel and split stocks altogether. Until a capitulation occurs, investors are willing to give the stock market the benefit of the doubt.

In other words, the mood during the surrender is not a bit more bearish than it was right before. When investors’ eagerness to believe fades, once and for all, their mood swings from extreme exuberance to extreme despair.

Not all of the previous bear markets ended in surrender, but most of them did. In a recent email, Jack Shanip, founder of advisory service TheDowTheory.com, said that based on his proprietary measure of capitulation, the ends of his “last ten bear markets have been signaled by” capitulation.

Why it’s important to understand this typical pattern of bear market psychology: Armed with knowledge, you’ll be better able to withstand the mood swings of your fellow investors. The late MIT economist Paul Samuelson once famously quipped that the stock market had predicted nine of the past five recessions. He could also say the same during market rallies: The stock market has predicted nine out of the past five bull markets.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to review. It can be accessed at mark@hulbertratings.com

more: The stock market usually drops to bottoms before the end of the Fed’s rate raising cycle. Here’s how to make that bet pay off.

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