Beware of Fake Rallies

Simon Maierhofer

Bear markets are smart. The job of the bear is to separate as many investors from as much of their money as possible. The bear knows this can't be accomplished if everyone knows he's around.

To get the job done, the bear 'kills with kindness.' To make a major decline seem more like a correction and buying opportunity, the bear generously provides rallies, mainly larger one-day gains. This keeps investors believing that the bear is not in control - which is what it wants.

Trojan horses would be an apropos description of such rallies. The chart below provides a visual of those Trojan horses. Notice that despite big rallies, the trend of the market has been unmistakably down.

The biggest on-day gain this year came right after the May 6 flash crash and lifted the Dow (DJI: ^DJI) by 405 points. Wall Street viewed that as a bullish signal.

On May 14, the ETF Profit Strategy Newsletter warned investors: 'History tells us, this it not bullish. We've found 16 instances where the DJIA rallied 400 points or more, 12 of them hit during the post-2007 decline, most of them in September/October 2008.'

Since then, the S&P (SNP: ^GSPC) has fallen as much as 10%, small caps (NYSEArca: IWM - News) have fallen as much as 18.7% and mid caps have fallen as much as 21.15%.

After forecasting a fall below the May 6 low of S&P 1,066, the ETF Profit Strategy Newsletter sent out the following note on May 20: 'We do well to remember that this period of time (September/October 2008) hosted some of the most powerful counter trend rallies ever recorded. There is a chance that we will see similar explosions' to the upside over the next days and weeks. If we do, we view them as opportunities to add more short positions.'

There were three days where the major indexes rallied more than 3% since, yet the indexes are close to their lowest level in over six months.

Similar to the January - April 2010 period, rising prices are likely to lull investors to sleep once again.

Asleep at the Wheel

No doubt the financial media played a big role in lulling investors asleep. The April issue of Newsweek exclaimed: 'America is Back.' But Newsweek wasn't alone. Below are headlines from April 26, the day the S&P peaked:

Bloomberg: 'U.S. stocks cheapest since 1990 on analyst estimates.'

Bloomberg: 'Biggest banks are back as JPMorgan, Citigroup turn corner on credit crisis.'

Wall Street Journal: 'Consumer mojo lifts profits.'

Wall Street Journal: 'Technical analysts see room to roll.'

Jon Markman on Yahoo Tech Ticker: 'S&P could hit 3,000 by 2020.'

On April 7, the Wall Street Journal touted: 'Dow 11,000 is only the beginning.'

Quite to the contrary, the ETF Profit Strategy Newsletter went out on a limb and noted on April 28: 'With various sentiment gauges having reached multi-year extremes and Investors Intelligence bullishness at 54%, the potential exists that Monday's high - which was only one point short of the 61.8% Fibonacci retracement at 1,220 - marked a significant top.'

Since then, the major indexes have lost over 10%, the most since the beginning of the post March 2009 monster rally. In fact, the S&P is trading at the same level today as it did on August 28, 2009. The last 19 trading days erased over eight months of gains. Wow!

How much lower can stocks go? You may want to sit down for this one.

There are different methods to determine the markets outlook. Historical precedents and technical indicators are two we'll discuss here today.

Major resistance - the 200-day moving average

Some swear by moving averages - especially the 200-day MA - others dismiss it as a lagging indicator. However, it's not important what you or I think, it's important what the big players think.

And the fact is that many institutional investors base their buy/sell decisions on the 200-day moving average. A solid close beneath the 200-day MA often triggers sell orders across the board.

On Thursday, the S&P 500 (NYSEArca: SPY) closed below the 200-day MA (1,102) for the first time in 216 trading days. This is bad news, especially since there was no resistance. Once below the 200-day MA, the S&P fell another 3% in one day.

To make matters worse, the S&P has attempted to break above the 200-day MA four times, and failed. The last attempt was met with a 55 point decline.

The Nasdaq (Nasdaq: ^IXIC), one of this year's leading performers (at least for the first four months of year), also closed below the 200-day MA, as did the Financial Select Sector SPDRs (NYSEArca: XLF - News) and Technology Select Sector SPDRs (NYSEArca: XLK - News).

In short, breaking below the 200-day MA is bearish, but it doesn't tell us how far stocks will fall. We'll have to look elsewhere for that.

Historical Extremes

There were literally dozens of sentiment and technical extremes that occurred right around the April 2010 top. These extremes moved the ETF Profit Strategy Newsletter to point out on April 16 that 'historically, there has rarely been a more pronounced sell signal. Aggressive investors may choose to act on it.'

ETFs recommended included the Short S&P 500 ProShares (NYSEArca: SH - News), UltraShort Financial ProShares (NYSEArca: SKF - News), UltraShort Dow30 ProShares (NYSEArca: DXD - News) and many others.

Due to the markets recent performance and ability to reach multi-decade extremes it becomes fairly easy to isolate historical precedents.

From October 2007 to March 2009, the Dow Jones (NYSEArca: DIA - News) dropped 53.77% or 7617 points. The only historic parallel that measures up to this kind of drop is the 1929 decline, which reduced the Dow by 48%.

The 71.15% rally from March 2009 to April 2010 can only be compared to the September 1929 - April 1930 rally, which lifted the Dow 49% in a matter of eight months.

This 8-month counter trend rally inspired the same kind of optimism we saw just a few weeks ago. Below are some comments and headlines taken from early 1930.

Beware of false optimism

Irving Fisher, Ph. D. in Economics: 'For the immediate future the outlook is bright.'

Harvard Economic Society: ' There are indications that the severest phase of the recession is over.'

Andrew Mellon, Treasury Secretary: 'There is nothing in the situation to be disturbed about.'

Julius Barnes, head of Hoover's National Business Survey: 'The spring of 1930 marks the end of a period of grave concern. American business is steadily coming back to a normal level of prosperity.'

Just a few weeks after the above assessments/forecasts were spoken, the Dow started its long and painful descent - it dropped an additional 86%.

Of course, Wall Street always says, 'This time is different.' Historic patterns show us that exactly this frame of mind has proven fertile soil for declines that are not different at all.

Motivated by this spirit, the biggest Dow percentage gains were recorded during the Great Depression and the September/October 2008 meltdown. The 'this time is different' spirit is most pronounced during periods of big declines and lure investors back into stocks just to experience yet another beating.

Once bitten, twice shy?

Great Depression historian and author John Kenneth Galbraith described the allure of a rally market during the 1930s as follows: 'The worst continued to worsen. What looked one day like the end, proved on the next day to have been only the beginning.

Nothing could have been more ingeniously designed to maximize the suffering, and also to insure that as few people as possible escape the common misfortune. The man with the smart money, who was safely out of the market when the first crash came, naturally went back in to pick up bargains. The bargains then suffered a ruinous fall.

The bear market was a remarkable phenomenon. The ruthlessness of its liquidation was, in its own way, equally remarkable.'

The market decline from 1929 - 1932 erased 29 years worth of gains. In March 2009, the market had erased 10 plus years worth of gains. According to some research, the decline of industrial production and world trade during the first nine months of the post-2007 bear market has been more pronounced than during the 1930s. Unemployment has hit the highest level since the 1930s.

Based on the giant gyrations of the post-2007 bear market, there is a good chance that more than 29 years of gains will be erased.


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