3 Reasons This Rally Can’t Be Trusted

09/01/2011 8:00 am EST

Focus: STOCKS

Three confirmation signals have already indicated a new cyclical bear market is upon us, and though rallies will be convincing, investors and traders must not get caught up in the bullish hype.

I’ve been warning bears for a couple weeks that the market was due for an aggressive bear market rally. That rally has clearly begun.

I often reference the “rubber band” theory of the markets when I talk to other traders. For those not in the know, the rubber band theory is nothing more than the tendency for any market to regress to the mean. And the further a market is stretched away from the mean, the more violent the snap back tends to be once the pressure is released.

In the case of a rubber band, the further you stretch it in one direction, the harder it snaps forward once you release it. Simple action and reaction.

Markets are really no different than a rubber band. The further you stretch the stock market, the more violent and persistent the snap back tends to be once the turn occurs. At the recent yearly cycle low on August 9, the S&P 500 Index (SPX) (SPY) had stretched to ridiculous levels, both sentiment wise and technically. This should generate an extremely convincing bear market rally.

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A normal bear market rally will typically last from four to ten weeks. (They have to last long enough to reverse extreme sentiment levels). Generally speaking, that takes a minimum of four weeks, and six to eight weeks is about average.

A bear market rally out of a yearly cycle low (other than a four-year cycle low, the move into a yearly cycle low tends to be the most damaging decline in the stock market. This year was certainly no exception) will quite often tag, and occasionally penetrate, the declining 200-day moving average. I tend to think that will be the case this time also.

My best guess is the market will rally up to the 200-day moving average, then dip slightly into the next daily cycle low around the end of September.

NEXT: The 3 Bear Market Warning Signs

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That should be followed by an extreme left-translated daily cycle that tops slightly above the 200-day moving average (I guessed at about 1300 on the chart below) and then moves down into the next intermediate bottom, due in late November or very early December. At that point, the market will make a lower low, confirming a new cyclical bear market.

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Actually, the market has already met all three confirmations that a new cyclical bear market has begun:

  1. Dow Theory sell signal: When the Dow Industrials and Transports both broke below the March low, a Dow Theory sell signal was triggered.
  2. A move below a previous intermediate bottom: When the S&P broke below the March low, it triggered a new pattern of lower intermediate lows.
  3. Moving average signals: The 50-day moving average dropping below the 200-day moving average, and the 200-day moving average turning down.

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Investors need to be prepared. This is going to be a very, very convincing rally. The tendency is going to be to buy into the media hype that this was nothing more than a severe correction in an ongoing bull market.

This was not a correction. This was the first leg down in a new cyclical bear market. And like all bear markets, it will be subject to violent countertrend rallies that toy with trader’s emotions and ultimately cause investors to ride the bear all the way to the bottom.

By Toby Connor of Gold Scents

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