The treacherous nature of bear market rallies

'The market itself is forecasting recovery' reads the recent headline of a well known financial publication. As someone who follows market movements very closely and tries to read signals the markets may give about future business conditions, I was also interested in the market's recent strength.

However, I would be extremely careful in concluding that rising stock prices after a terrific decline, such as we had in the NASDAQ since March 2000, do signal improving business conditions. For a market, which has become very over-sold, it is only natural to rebound, but frequently these rebounds are merely bear market rallies, which are subsequently followed by vicious declines.

Probably the most famous bear market rally in history is the rise, which took place following the October crash of 1929. Stocks began to recover strongly following the November 13th 1929 low amidst wildly bullish comments and confident statements by a very large number of respected Wall Street personalities.

In fact, for a while the bulls were right. From a low at 199 on November 13 - down from the September 4, peak at 381- the Dow Jones Industrial rallied to a high of 294 in April 1930 (up 48%). This famous and well-documented bear market rally took place for a number of reasons. After the October 29 crash, the market had become very oversold - incidentally far more oversold than the US stock market's position on September 21, 2000. Thus, a technical rally was natural.

Also, the Federal Reserve Bank cut the discount rate immediately following the crash from 6% to 5% on November 1, 1929, to 4.5% on November 15, and to 4% on January 30, 1930. Subsequently the discount rate was repeatedly cut to 2.5% in June 1930, to 2% in December 1930, and 1.5% in mid 1931.

The interest rate cuts after April 1930 did, however, no longer support the stock market, which began to sell off once more. And by the end of the year 1930, the Dow Jones Industrial had broken below the November 1929 low and fell to 158 (from there it fell 41 in July 1932). Another reason for the 1929/1930 rally was that the economy held up following the October crash, which led a number of leading business and stock market personalities to make positive comments and to buy equities.

During the first six months of 1930, the business curve of the Harvard Barometer was almost horizontal and, therefore, did not signal a recession. Thus, the October 1929 stock market crash was widely regarded as a financial accident - a direct consequence of excessive speculation, but not as the beginning of an economic crisis that was to jolt the social and economic structure of the entire world.

No one anticipated a recession, let alone a depression. Charles Mitchell who headed the National City Bank, announced soon after the crash that the trouble was 'purely technical' and that 'the fundamentals remained unimpaired'. While President Hoover assured the American people that 'the fundamental business of the country, that is production and distribution of commodities, is on a sound and prosperous basis.'

From an article by noted economist Marc Faber which I strongly recommend.