However, it’s important to distinguish between a garden variety ripper rally and what might be called a “Reaper Rally”. A reaper rally is essentially a bear market rally, a dead cat bounce, a bull trap. But calling it a reaper rally brings out what’s at stake: the financial reaper.
The main operational theory for how the stock market works according to economists is the efficient market hypothesis. It is impossible to beat the market, in short. An alternative theory is that the stock market is akin to a casino, where institutions are the house and retail investors are the players.
It’s possible to beat the house. But unlikely.
This theory has a number of implications. Perhaps most importantly, the “goal” of the stock market is to squeeze as much money from as many people as possible, on both the way up and the way down.
The stock market often moves counterintuitively for just this reason. For example, suppose that most people are bearish. The self fulfilling nature of stock trading implies that this bearishness will be reflected in declining prices.
However, it is possible for “smart” money to go long when everyone is bearish, pushing prices up temporarily, allowing the smart money to begin to short at a better price. This is why just when the market is forming a highly predictable pattern, that’s when the pattern breaks down.
In this context, a reaper rally is a bear market rally, whose goal is to allow a more attractive entry point for smart money shorts. It’s important to understand that when prices shift sharply, known as pivot points, there are literal bankruptcies happening. Another one meets the financial reaper.
Even a dead cat will bounce dropped from a great enough height, bulls will be trapped, suckers will be pulled in, and shorts will be squeezed. Now you can add another phrase to your lexicon: the reaper rally.
Of course, correlation is not causation. We’re not claiming that last week’s rally was The Reaper Rally, although the rally failed to continue this week, which suggests it might just have been exactly the market fake out described here. We’re also not calling that a reaper rally in the coming weeks.
But unlike Blue Oyster Cult, we recommend fearing the financial reaper.
Don’t lever up maximally in any direction, don’t become completely bearish or bullish, and don’t try to time the market. Instead invest for the long run by dollar cost averaging into companies you believe in.
Nevertheless, often times pundits’ analysis is no deeper than the aforementioned. Notice how often financial news coverage puts 2 events back to back as if they are related.
“Stocks declined, despite strong consumer sentiment.”
“Stocks climbed, on the backs of strong earnings.”
“The market went up despite bad news”.
But, these are just narratives. Sometimes, the reality is the market went up because of bad news.
In other words, in a bear market, a reaper rally sucks the shorts dry, all the while fooling a new crowd of investors into going long, slaying investors on the way up and down.
Stock market valuations are ultimately a combination of 2 major factors: expected earnings and market multiples. Expected earnings are how much profit a business expects to make (historically, around 7–8% annually), and market multiples are the average multiple of a company’s market cap compared to their earnings (historically, around 15x).
Therefore, the market may hypothetically rally on bad news, if that means that central bank policy may move in a less hawkish direction, effectively increasing market multiples or boosting expected earnings.
But bad news is still bad news. Until we know more about whether inflation is transitory, whether we are in or near a recession, by how much the Federal Reserve will have to raise rates by, and so on, sentiment remains unclear and the vigilant trader must beware the reaper rally.
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