During a staff meeting last Thursday, I discretely checked on how the market was doing. (I was paying attention in the meeting — mostly!) With the markets in full rally mode, I said to no one in particular, “When does the NASDAQ rise 7% in a single day?”
I meant it as a rhetorical question. However, without skipping a beat, Mark immediately replied, “In a bear market.”
And for the most part, that’s right. Since 1971, of the 20 largest one-day gains in the NASDAQ, the vast majority of them have come in the midst of bear markets while the index was still heading lower. Only in a couple of instances — 2009 and 2020 — did some of the NASDAQ’s best days come as the market was in what would turn out to be a sustained recovery.
What can we learn from that? First, bear markets do not move in a straight, steady, downward path. Their trip to the basement is typically interrupted several times by strong upward jolts. And the false hope such moves engender can be especially painful.
A unique type of pain
One of the “cognitive biases” we have discussed most often in this blog and the SMI newsletter is loss aversion. It’s the well-researched idea that, for most of us, the pain of loss is felt much more acutely than the pleasure of a comparable gain.
But that addresses just one of the painful parts of an investor’s journey. Another is the unique pain of false hope. While I’ve never seen a scientific study that has attempted to measure its magnitude, anyone who has ever gotten their hopes up for anything, only to have them dashed, knows all too well how wrenching such pain can be.
“Hope deferred makes the heart sick” (Proverbs 13:12).
As investors, the best we can do regarding these false hope-inducing bear market rallies is to expect them. To be as emotionally prepared as possible. To say on days like last Thursday, “This is typical for a bear market, and it probably does not mean that the coast is clear.”
But therein lies the rub — the word “probably.” It’s highly likely that a rally during a bear market is just a temporary interruption in the trend, but not an absolute certainty. And that leads to a second lesson from bear market rallies: it’s essential for investors to use a time-tested, objective investing process. You expected me to say that, right? Fair enough. But it’s true.
If left to our own devices — our own emotions — it’s a virtual certainty that we would get more investment moves wrong than right, and we’d be filled with stress at every decision point along the way. On the other hand, SMI’s mechanical, trend-following investment process is designed to get more moves right than wrong, while reducing investor stress.
It won’t catch a big move right at the start of what turns out to be a new bull or bear market, it can’t guarantee gains every month or even every year, and it won’t inoculate you from all pain. But it’ll get portfolios aligned with the overarching market trend soon enough to capture many of the gains and sidestep many of the losses generated through each market cycle. And perhaps most importantly, it will help you latch onto true market trends while ignoring the moves that are most likely to break your heart.