First Quarter Review: Bear-Market
Bottom or Just a Bounce?

For most of the first quarter, investors had little to cheer about. While the acute financial panic of last fall began to abate, the general economic news continued to get worse. One government announcement after another received a vote of no confidence from a market unimpressed with Washington's attempts to help stem the economy's bleeding.

Then, out of the blue, the market started rallying in the second week of March. In three furious weeks, it had rallied more than 23%, the sharpest rally of its kind since 1938. Investor psychology pivoted sharply, from overwhelmingly discouraged to cautiously optimistic. Few were willing to actually call it a bear-market bottom, but most everyone was secretly wondering if it just might be.

Here's the unfortunate reality. While we all hope the bottom is in on this bear market, we have to take the recent rally with a healthy grain of salt. That's because bear markets are famous for just this sort of vigorous rally. They even have a name: bear market traps.

These types of exciting rallies are largely what keep people investing through prolonged bear markets as they keep hope alive — only to give way to further lows. In the worst bear market of all, there were six rallies of 20% or more between the 1929 peak and the eventual 1932 low.

That said, bear markets often do bottom unexpectedly, then rally sharply in the initial stages of the next bull market. The fact that bear-market rallies and new bull markets look so similar is precisely what makes it so tricky to identify them correctly until after the fact.

In light of this, what investment moves should you make? Keep following your plan!

The market is inherently unpredictable. We know the chances are extremely high that bear markets will bottom and turn higher before the economic news changes for the better. But bear markets often go through more than one rally that seems to fit that description before finally bottoming.

Instead of trying to predict the market's future — and which investments to buy as an extension of those predictions — we rely on Upgrading to lead us to the funds best positioned to take advantage of the market's current condition. As the top line of the table above shows, in the first quarter of 2009 that meant being invested more conservatively than the overall market. Eventually, as the next bull market takes shape, the Upgrading process will lead us to more aggressive funds.

The effectiveness of Upgrading over time is demonstrated in both the "From 2003 Bottom" and "Past 10 Years" sections of the table. The returns from the prior bear-market low in 2003 illustrate Upgrading's ability to create significant value over a complete market cycle during a time when the overall stock market advances very little.

Upgrading processes market changes in a deliberately slow fashion. Any new bull market will have to prove its staying power before we make wholesale changes to our portfolios. That process helps shield us against the possibility that this has been just another bear market rally.

If the market continues higher, everyone will be happy. But if there's more downside ahead (or at least a retest of early March's lows), hopefully we'll be prepared to handle it — both emotionally and in our portfolios.

Mark Biller is Sound Mind Investing's Executive Editor. His writings on a broad range of financial topics have been featured in a variety of national print and electronic media, and he has appeared as a financial commentator for various national and local radio programs. Mark is also the Senior Portfolio Manager of the SMI Funds.

• How Should Your Investments Change
  As You Move Through the Seasons of Life? 
• Overview of SMI's Upgrading Strategy
• Overview of SMI's Just-the-Basics Strategy
• Performance History
• 2009 SMI Allocation Guide: Weighing The Risks 
• Subscription Information

• Got a question or comment about this article? Discuss it on our Message Boards.