Bull Traps Lead to Losses in the Bear Market
The rise in stock markets looks reassuring and exciting. In just two weeks, it has regained more than half of the ground lost during the three-month liquidation. However, this observation contains the warning that another, deeper wave of selling could soon occur.
First, look at the stock market situation. The sell-off in August and October was accompanied by many negative signs. (See my previous articles for explanations.) Then came the last two weeks, with indicators that are likely false positives, as shown below.
Daily movements of the S&P 500 from June to November 10, 2023
The problem is that starting a new bull market takes time. Investor attitudes must improve by “climbing the wall of worry”. These are the false reversals that occur when a sell-off stops. Such reversals, if dramatic enough, can then turn into “bull traps.” These loss-making stocks result from enthusiastic, optimistic buying that goes awry when selling suddenly returns.
Why “trap”? Because when the rise experiences the first downward reversal, it is considered a new buying opportunity. Then, when the rise fails to resume, we realize that the old liquidation is back. Thus, investors find themselves trapped by the painful choice: either sell now at a loss, or hold and risk losing more later.
Note that human nature, once again, is the cause of erroneous opinions and actions. The following descriptions explain the bull trap and the role of human nature well…
Excerpt from an article in Financial Strategists (September 7, 2023): “Bull traps“
“What is a bull trap?
“A Bull Trap is a false market signal indicating a reversal from a downward trend to an upward trend in the price of a financial asset. This misleading signal leads investors to buy, anticipating a rise in the market.
“However, the price of the asset drops shortly thereafter, trapping bullish traders who bought in anticipation of growth that will never materialize.”
…
“With the rapid and interconnected evolution of today’s financial markets, the prevalence and impact of bull traps has increased due to rapid fluctuations in investor confidence.”
“Role of market psychology in creating bull traps
“Market psychology plays a central role in the formation of bull traps. Investors, driven by fear of missing out (FOMO), may jump into the perceived uptrend without properly assessing market conditions.
“This rush to buy can accelerate the rise in prices, further fueling the perception of a bull market. But when this optimism is not supported by fundamentals, the correction can be rapid and severe, resulting in a trap bullish.”
The bottom line – Stock investors weren’t bearish before the rally
While some articles proposed this idea and worse (panic!), polls showed little concern. In fact, the very good weekly US Advisor Confidence Report showed a healthy reading of 50% bullish/24% bearish as of October 24, just before the upward reversal. November 7 was similar. Most likely, the November 14 figure will be even better.
Furthermore, the rapid rise in the stock market over two weeks confirms this low attitude of concern. If investors were truly worried, they (and the media that tends to reflect their feelings) would still be dealing with the negatives. Additionally, the market would experience fluctuations and work its way towards a reversal (but only if the fundamentals supported such a move).
Therefore, do not take this recent rise as an indicator of a better future. If a bull market actually begins, the path would be tortuous. All of these negatives that are still present need to be eliminated before we can once again have a runaway, uncontrollable, fashion-driven bull market.