The Bull Hangs By a Thread

02/07/2008 12:00 am EST

Focus: MARKETS

Bernie Schaeffer

Chairman and CEO, Schaeffer's Investment Research

Bernie Schaeffer, editor of the Option Advisor, says the market’s ability to hold certain support levels will tell us whether the bull market is over and a bear has begun.

In my bullish market forecast for 2008, I identified two major wild cards that could upset my scenario.

1. The bullish case was strongly supported by the price action in the Standard & Poor’s 500 index (SPX), namely the fact that the 80-week moving average had held as support on a weekly closing basis on all pullbacks since 2004. This moving average had become a line of demarcation for the bull market that began in 2002-2003. Unfortunately, the S&P closed below [this moving average] on the very first week of the New Year.

2. The Fed was fully capable of putting a stake through the heart of the bull market if it remained obtuse and out of touch with the message of the financial markets. Finally, after watching world markets implode on a US holiday on Monday, and fearful of an all-out market crash, the Fed acted to cut rates by 0.75% on Tuesday morning. So the markets won the battle with the proactivity-challenged Fed, but only after a huge hit to share prices and to the Fed's vanishing credibility.

There are certainly some encouraging indications of climactic bearish sentiment, which is a necessary condition for a market bottom. The CBOE Market Volatility Index (VIX) [recently] spiked to a level slightly higher than that of the August market bottom; the slope of the VIX futures curve became inverted, which has been consistent with market bottoms; various measures of put volume spiked higher, and the ISEE all-equities call/put ratio reached the extreme levels of August 2007. Short interest is near record levels, which can help spark the "V rallies" off market bottoms and, finally, anecdotal sentiment as reflected in the financial media is bordering on despair and expectations for earnings and the economy are plummeting by the day.

But the contrarian power of sentiment extremes emanates most powerfully when the sentiment is counter to the price action of the market. When sentiment indicators reach or exceed previous extremes, it is a necessary but by no means sufficient condition for a tradable rally.

This is why an accurate measure of the current price action environment is so critical. The current signs of stabilization around the 160-week moving average are encouraging and are in contrast to what occurred during the bear market of 2000-2002. But I would feel much more constructive about the market if the 80-week moving average was [also] retaken.

So, with the bull hanging on by his thumbs, I would suggest a healthy dose of cash of 25-50%, an ongoing major investment in gold through the StreetTRACKS Gold Trust (NYSEArca: GLD) exchange traded fund and through gold-mining stocks) as this is the one sector that will unambiguously benefit from the Fed's newfound proactivity, some selected Internet plays, and some plays in the agriculture sector. And I would continue to avoid any exposure to the financial sector.

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