Don't Buy into This Rally

03/26/2009 1:06 pm EST

Focus: MARKETS

Dan Sullivan

Editor, The Chartist

Dan Sullivan, editor of The Chartist, says most of the damage of the bear market has been done, but he thinks we’ll see another leg down before it officially ends.

One indication that this bear market is winding down is the preponderance of doom-and-gloom books on the market: The Two-Trillion-Dollar Meltdown, The New Economic Disorder, The Return of Depression Economics, The Coming Economic Collapse, Financial Shock, Plunder and Blunder, The Origins of Financial Crisis, Empire of Debt, Guide to the End of Wall Street as We Know It. It is just the opposite of the get-rich-quick books that were on the shelves at the end of the dot.com era.

We are working under the premise that the bulk of the damage in this bear market has already occurred; however, we strongly advise against buying into this rally. We say this because we expect the market to trace out a “W” formation prior to our models flashing a buy signal, which will mark the conclusion of the bear market.

This is what occurred at the bottom of the previous bear market, which ended back on October 9, 2002. The bottoming process entailed two very explosive failing rallies. The first rally began on July 23, 2002 and ended on August 22nd. Over the period, the Standard & Poor’s 500 moved from 797.70 to 962.70, gaining 20.7%; however, by October 9th, all of the ground gained on the rally and then some was given back with the S&P hitting its lows of the bear market at 776.76.

Officially the bear market ended on October 9, 2002, but there was another failing rally in the interim which saw the S&P 500 tack on a gain of 15.6%, moving up to 938.87 by October 27th. From that point, the S&P proceeded to test its October lows, dropping back down to 800.73 by March 11, 2003.

The next rally was for real, which in our opinion was the start of the kick-off stage of the bull market. By May 30th, the S&P was 9.5% higher and in the process had broken through the peak of the “W” formation.

Several bear markets have ended with “W” formations, which entail a sharp rally followed by a pull back with a test of the lows: 1973-74 ended with a “W” formation as well as 1962.

The obvious question is: What if the market just proceeds to go straight up (a “V” formation) along the lines of 1970 and 1982? Our answer is that there will be ample time to take worthwhile positions in the emerging high-relative-strength stocks. Even if the beginning of the next bull market turns out to be a “V” formation, we would expect our models to flash a timely buy signal. Trust us, we have no intention of missing the next bull market, which, if history is any guide, is going to be a good one.

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