Not Out of the Bear’s Shadow Yet

10/25/2011 8:30 am EST

Focus: MARKETS

Jack Adamo

Editor, Jack Adamo's Insiders Plus

Even though we’ve seen some encouraging signs, by historical measures the bear is still stronger than the bull, writes Jack Adamo of Insiders Plus.

It looked like we were sliding back into the downtrend early this week, but the losses were all erased on Friday with a good show of strength. Breadth was impressive, and the market moved into a solidly overbought condition after having been oversold for many weeks.

As I’ve mentioned in the past, overbought and oversold refer to the normal range of volatility in the market, which tends to move in a band approximately 3% above and below a 21-day moving average. Why it does that is mystery, but history shows it does.

Extended periods outside the range usually indicate a change of market direction. However, an instance here and there of a few weeks outside the envelope is not enough; the “over” condition must persist and repeatedly breach the boundaries.

With our portfolio being so deeply short, the strength of this rally felt a little worrisome, so I went back to the books again; revisited my charts; checked back with the technical analysts with good track records; and looked up what the smart economists were saying. (Even though their views mean nothing to the markets in the short term, I like to know if they see anything noteworthy ahead.)

I saw nothing to change my opinion of the market. Fundamentally, nothing has changed. Monetary options are also exhausted. Not that the Fed won’t try some form of QE; it just won’t work. Lastly, technical indicators are all still bearish.

Let’s examine that last point.

If you look at S&P 500 daily price charts with 50- and 200-day moving averages during the bear market of 2000 and the bear market of 2008. there’s one striking difference. During the bear market of 2000, the S&P rallied back to or slightly above its 200-day moving average three times on its way to a much lower market bottom.

In the 2008 bear market, the whole move was much sharper, and the S&P only rallied back to its 200-day once. That was in May 2008.

At this point, we’re actually about 20 points (or about 1.5%) below that average, so it would not be at all unusual for this rally to run another 3% to 5% from here. I just hope that if it does, it does it quickly.

These counter-trend moves are nerve-wracking. The longest one I’ve seen dragged out for over four months, but most are shorter, and the declines can be quite sharp. That’s why I’m not selling any of my hedges. You can cover your shorts only to have the market drop 4% in one day.

The long-term indicators I watch are still solidly within bear territory. The Chartist agrees. Here’s a quote from last week’s letter: "Looking further out, we expect the bear market to prevail. Once key averages move through the current trading range, there will be formidable overhead resistance in evidence at the mid-June lows as well as the respective 200-day lines."

This brings to mind the first rally of any consequence which took place during the last bear market between early March and mid-May of 2008. The S&P 500, Dow, and Nasdaq were all turned back at their respective 200-day lines, with all of the gains being erased in short order. Recall that The Chartist is the most successful long-term market-timing newsletter over the last 30 years.

I should also mention that, despite a few favorable items of economic news recently, Initial Unemployment Claims remain over 400,000. The Economic Cycles Research Institute’s Weekly Leading Index fell for the 11th straight week, and the Institute has not made any further announcements to contradict its call for a recession: “And there’s nothing that policy makers can do to head it off.”

The ECRI has, by far, the best record of predicting recessions of any organization extant, and that includes not giving false alarms.

Another Tool?
Although I have full faith in the hegemony of this bear market, I continue to look for ways to make it easier to ride out the rallies. I think I may have found a good one. I will have to test it in real time, but back-testing supports a positive view.

It’s nothing esoteric or proprietary. In fact, the very bearish David Rosenberg of Gluskin Sheff warned back in September that a rally was probably in the offing, using this indicator. It is the Market Vane sentiment indicator.

When it falls to around 40% bullish, it has historically been a good time to cover your shorts. There have been exceptions, like 2008, for example. But the long-term probabilities show that easing up on your hedges and even going long is, overall, a winning tactic at these junctures.

As of last weekend, the indicator was back up to 47%, which is still a pretty good contrary indicator, but there’s not enough headroom left to make it worth our while to make any move right now.

However, I’ve added this to my weekly checks. If we get down there again—it probably would not be soon—we will lighten up on our shorts, and maintain that position until and unless the market hits its 200-day moving average or breaks lower again.

The difference in our returns by doing this will probably be minimal, but it should be easier on our nerves, and that counts for something. Especially for old buggers like me.

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