The Bear-Market Rally: Demystified

In case you haven't been paying attention, the stock market has had some interesting action lately. Though I didn't have the guts to actually put my money where my mouth is, I think this perfectly exemplifies the notion of contrarian trading (where you bet that the collective market wisdom is wrong). I'm going to try to keep this simple and explain it in pictures:

Here's a chart of two months of trading. The Dow drops 29% in this period. Thing's ain't looking too good.


Now look at the six trading days following the market bottom on October 27. The bailout is working! The capital infusions are strengthening our good banks! The recession is over! That's what the press wants you to think...There was very little bad news in the newspapers that I was aware of, and I'm sure there were people thinking to themselves "The stock market is a leading indicator of our economy, now that it's going up, it must mean that we're out of a recession! I mean, we've already been in it for 10 months or so and the average recession is only 11 months long, so it's gotta be over soon." The market rallies 18%.


Now look at the past two days:

The market drops 10% in TWO DAYS! The volatility is incredible, in Intelligent Investor, Benjamin Graham (the mentor to Warren Buffett) claims that average price appreciation on equities is about 4% a YEAR! Yes, when you smooth things out over ~250 trading days a year, it's reasonable, but the market swings taking place today are a few-times-a-century phenomenon. I put cash in my brokerage account so that I could buy-in once the two-week rally crashed. We'll see if tomorrow looks good.