After a nearly 25% rally off the lows in June, Wall Street strategists have warned that stocks are in line for a pullback – having come too far too fast.
Bear markets of the early 1980s, early 2000s and 2007-08 have exhibited similar rallies and while it is important to note trends, investors should be wary of reacting in the short-term.
Jordan Jackson, global market strategist at J.P Morgan Asset Management, believes markets are primed for a pullback.
“The strong rally from the recent lows has been a welcome reprieve, however, we are not signaling the ‘all-clear’ from here,” he said. “Work from our private bank suggests bear market rallies are common, however the strength of this rally is somewhat unique.”
‘Nebulous’
Jackson acknowledged that the definition of a bear market rally is somewhat nebulous and detailed a few parameters for it to be considered.
He said it must follow a drawdown of at least 20% from the market’s previous all-time high and there must be a gain of 10% of more from the bear market’s prior low.
“It must be followed by another decline that represents a new low for the sell-off – for instance, not being the first leg in the market’s recovery back to all-time highs,” he added.
“According to those parameters, we found that five of the six major selloffs since the 1970s had at least one relief rally of more than 10% before dropping again to make fresh lows.”
He explained that the Global Financial Crisis and Tech Bubble each had three; the late 1980s bear market – which was not accompanied by a recession – had one.
A history of bear markets
“The point is intra-selloff rallies can and have happened,” said Jackson. “I don’t suspect we will retest the lows, but another 10-15% pullback from current levels seems very possible.
“One reason is forward earnings over the next year have not been revised low enough to reflect the weakening economic backdrop.”
That said, what then needs to happen to signal the market’s long-term recovery?
Two essentials for that recovery, according to Jackson, is a more cautious Fed that keeps rates below 4% and inflation moderating.
“The former would help keep interest costs on corporate balance sheets manageable, while the latter could allow for less need to pay more in wages to attract that additional worker given price increases are more manageable across consumers, and input costs would come down keeping margins intact,” he said.
“A weakening in the dollar would be supportive also for export and global businesses that have operations overseas.”
Gauging the breadth of the market
In order for the market to be considered in stable territory, CNBC’s Jim Cramer identified a few factors that would need to occur.
He said oil prices need to stabilize, rampant food inflation needs to stop and added that the advance-decline line needs to improve, commenting: “This is an all-important gauge that measures the overall breadth of the market — how many stocks are going up versus down and when you see it going steadily higher, that’s a solid precursor to a run.”
The advance/decline line plots the difference between the number of advancing and declining stocks on a daily basis.
As a cumulative indicator, a positive number is added to the prior number, or if the number is negative it is subtracted from the prior number.
Jackson said: “Higher oil prices really only benefits energy companies while raising the cost of doing business for other sectors and so I would broadly agree with him here.”
In terms of how broad-based the rally is, Jackson said many have participated in the rally since the recent lows. He said as of Monday’s close, nearly 30% of the S&P’s members are in overbought territory.
“That’s a pretty rare occurrence going back to 2000 (99th percentile) and underscores just how broad-based the rally off the June lows has been.
Jackson added that over the last three weeks, while growth has led the charge, both growth and value indices are up +3%.
See more – How historical rallies compare within bear markets
