As this year comes to an end we will see all sorts of predictions about what kind of future 2009 holds in the market. While predictions make for interesting reading, they are often wrong.
I believe it is more constructive to seek out risks that lie ahead and construct a game plan in the event those risks play out. The goal with this exercise is not to be right but to be prepared ahead of time for the unexpected. This type of preparation means you won't have to react on the fly in an emotional state as events play out.
First, a History Lesson
The roughly 40% decline in the S&P 500 qualifies 2008 as one of the worst years on record. The decline was rapid, causing a great deal of investor pain. After such a huge fall-off there could be more risk from here to the upside.
The market has of course had fast, painful declines in the past, and often they have been followed by massive rallies. Consider this: In 1935, the Dow Jones Industrial Average soared 40% followed by a 27% rise in 1936. This massive two-year rally came on the heels of the worst economic period in our country's history. How many people do you suppose saw that one coming?
While I don't have access to sentiment data from the 1930s, it is a reasonable assumption that going into 1935 sentiment was at least as bad as it is now. At 104.04 on Dec. 31, 1934, the Dow was down 73% from its 1929 high; yet, the rally of 1935 and 1936 happened anyway. It was not a new bull market, more like a massive bear market rally.
2009 Rally: Leaders, Velocity Are Key
If the market can make a 72% move higher in the beaten-down 1930s, why not a 30% to 40% move now? This is not a prediction but more of a planning issue.
What is the best thing to do if there is a huge rally that catches people by surprise? People are afraid of a big decline in the market. A big move down certainly could happen from here of course, but the way the market tends to work, the risk of a big decline is much less after we've already experience a big fall-off. People are very afraid these days, and usually big declines are a byproduct of not enough fear.
If there is a big rally, people will wonder whether it is a bear market rally or the start of a new bull market. The right answer to that question could be in the makeup of such a move. I will be looking for clues as to what leads such a rally and how quickly a big a rally occurs.
A new bull market will get its leadership from some sector that did not lead the last bull market. Just as tech lagged from 2003-07, it is likely that emerging market, energy and commodity stocks will lag the next bull run.
So if there is a big rally in 2009 and emerging market, energy and commodity stocks are out in front of the move, I would take that as evidence of a bear market rally. If leadership comes from things sectors like health care, telecom or Japan then I would be more inclined to view such a move as new bull market.
The other tell for the bear market rally/new bull market conundrum would be the velocity of a rally. If the market climbs 30% in a couple of months, I would lean toward bear market rally. Don't dismiss 30% in a couple of months, as the S&P 500 went up more than 20% on a closing basis from Nov. 20-Dec. 9. I would take a longer rally with a smaller move up to be the start of a new bull market.
While there may be no rally at all, I believe there is plenty of reason to expect some sort of move up that catches most people by surprise and this would provide an opportunity. The type of opportunity depends on what type of market participant you are. For some people, this could be a trade and other people may have learned the hard way they have too much equity exposure and could use such a move to rebalance into a more conservative target allocation.
The reason to plan for this now is that it could happen, and if it does it is a good bet that most other people will be reacting on the fly, which increases the chance of being wrong. Think about it now and you reduce the chance of being wrong.