The Bull's Lessons for the Next Bear Market

You've probably read a spate of articles on the lessons of the financial crisis, the Great Recession and the devastating bear market. Now, for something different, I offer lessons of this bull market.

Yes, I know some of you think that the recent merrymaking is nothing more than a bear-market rally and that more pain is on the way. You may be right. The nation -- indeed, the world -- still faces plenty of economic challenges. And the stock market's sell-off on Oct. 1, in response to a weaker-than-expected report on manufacturing activity, was certainly worrisome.

But when stocks suddenly reverse course in an atmosphere of pervasive gloom and ascend nearly 60 percent without pause for seven months, it's time to take notice. Let's face it: Whatever you call the rally, missing one of this magnitude (and an even bigger advance in foreign stocks) is a serious error of omission. So it's worth examining the lessons of the stock market's amazing recovery.

-- The stock market turns up when pessimism is rampant. Around the time that stocks bottomed out in March, media coverage provided a nearly perfect contrarian indicator, such as in the cover story in the March 9 issue of Time, a special report on the economy headlined "Holding On for Dear Life." The cover story of BusinessWeek's March 16 issue was "When Will the Bull Be Back?" The subtitle: "Most signs point to more stock market pain. But opportunities are emerging for very, very long-term investors." As it turns out, shareholders have endured little pain since March 9. And I wonder whether seven months qualify as "very, very long-term."

-- A bear market associated with a recession almost always ends in the middle of the economic downturn. The stock market is what the pros call a discounting mechanism. This means that stock prices tend to anticipate the future. Looking back at 11 significant declines beginning with the one at the end of World War II, the only time this rule failed was early this decade: The 2000-2002 bear market didn't end until 11 months after the end of the 2001 recession.

The U.S. economy contracted 6.4 percent in the first quarter and 0.7 percent in the second quarter. But thanks to various Federal Reserve policies and Uncle Sam's assorted stimulus programs, the economy almost certainly grew in the third quarter. On average, economists think that real (that is, inflation-adjusted) gross domestic product jumped 3 percent, and they see expansion of 2.4 percent in the fourth quarter -- not rip-snorting growth, but growth nonetheless.

-- Don't obsess over earnings; they always lag behind the market. I'll let Jim Stack, a money manager in Whitefish, Mont., who edits the InvesTech Research Market Analyst newsletter, explain: "No matter how many times it is said and everyone says they know it, for some reason lousy earnings always become an emotional block for investors in a new bull market. In the huge bull market of the 1990s, the stock market climbed for over a year (throughout 1991) before corporate earnings even hit bottom! One of the most valuable historical lessons is to completely ignore earnings and forecasts in the first six to 12 months of a new bull market." Incidentally, Stack called the market's March bottom.

-- Once you decide to get in, don't wait for a correction -- there's no telling when it will come. On average, a correction -- defined as a drop of 10 percent -- comes 285 days after the start of a bull market, according to the Leuthold Group, a Minneapolis investment research firm. In the great bull market of the 1990s, which began in October 1990, the market rose 249 percent over 1,724 days before the correction.