Even in the midst of a deep and prolonged bear market like we are currently experiencing, it is normal to see shorter periods when the market advances. Sometimes these rallies last a few days. Other times these advances can last three or four months. These are commonly called “bear market rallies” or even “bear market traps.”

The trap reference comes because as the market begins to advance, investors can be fooled into thinking that the bear market has ended. Not wanting to miss out on the potential gains of a new bull market, these investors begin buying, only to suffer more losses when the bear market reasserts itself and the next downturn occurs. In other words, they were trapped into thinking that the bear market was over when it was actually just taking a breather.

Major market indices have generally been advancing since about Thanksgiving. With the Federal Reserve dropping interest rates to less than a quarter percent this week and stocks showing a modest rally, some investors are getting the urge to jump back into the market. Is this really the end of the bear market? Or is this latest move just a bear market trap?

Let’s look at a chart of market activity to see if we can make a better judgment about the current situation. The chart below shows daily price activity of the S&P 500 over the past year. The gold line is a 50-day simple moving average (MA). Notice that on this current rally, the index has reached the MA and is currently holding at that level. Looking back over the past year, there are several other times when the index touched or exceeded its 50-day MA. In the spring the index remained above its MA for about an eight-week period, even though the bear market remained intact.

The middle portion of the chart is a moving average convergence divergence (MACD). If this current move were truly a change in trend, the MACD would rise above the zero level and remain above it for an extended period. The bottom portion of the chart is a relative strength index (RSI). During a bull market with strong momentum, the RSI trends above the 50 level for extended periods and moves up into the 75 to 80 range. While the RSI is currently at the 50 mark, it is too early to determine whether or not it will be able to trend above that level for several weeks or months.

So while these technical indicators reflect an index that is showing more strength than it was a month ago, there is nothing so far that would indicate that the long-term bear market trend is over.

To gain a little more perspective, let’s look at one more chart taken from the market’s last significant bear market period and the beginning of the bull market that followed. This chart below also shows the S&P 500 over a two-year period of 2002-2003. I’ve also included the same technical indicators: a 50-day MA, MACD, and an RSI. Notice that the index essentially made a triple bottom before beginning a sustained advance in the spring of 2003.

Once the trend changed from a bear market to a new bull market advance, the index trended above its 50-day MA, above the zero level on the MACD, and above 50 on the RSI. When the current bear market ends, one could expect to see similar behavior.

Based on what these indicators are showing, it seems likely that the recent upward move in this and other indices is a rally within a bear market and not a change in the long-term trend. If that is the case, we could see another month or so of upward momentum, followed by another downturn. Of course market behavior is unpredictable and this is just an opinion based on our interpretation of current market conditions.

Because of the Christmas and New Year holidays, we probably will not publish a report for those weeks unless there is a major change in market conditions. Please enjoy the holidays with your friends and loved ones.
 

F.S.

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Over the past week, most of the economic news has been bad, but stocks have rallied. As I write this, stocks are mostly even for the day, even though the Labor Department reported this morning that unemployment claims reached a 26-year high. One possible explanation for this investor optimism is that investors believe government efforts to resolve current economic problems will be successful. While we all hope that is the case, this situation is unlike anything experienced in the past and no one is certain exactly how to fix what is broken.

A few years ago I bought a small gray horse. We named her Shelby. She had been captured as a wild mustang in Nevada and we spent several months getting her to calm down and tolerate human interaction. We had gotten her to the point where we could put on a saddle and lead her around with someone sitting on her back. But she remained moody and temperamental most of the time and we did not trust her to be ridden without assistance.

My son came home from college and brought a friend along to visit. The two of them both were working part-time on ranches to help cover the costs of their schooling. They were both strong, strapping young men and when they learned that we spent several months working with the small gray horse and still could not easily ride her, they announced they would go out, teach her who was boss and get her ridden. While it sounded like a reasonable plan, those of us who had been working with Shelby had some reservations.

For a time their plan seemed to go well. Shelby stood calmly while they tied her to a tree and she barely flinched when they put the saddle on and tightened the cinch. But when my son tried to get into the saddle she pulled away from his friend. After three or four unsuccessful attempts to get mounted my son and his friend decided it was time to apply some muscle and impose their will on the little mare.

A few minutes later I led an unsaddled Shelby to her corral while my son and his friend made a visit to the emergency room. While they were young and strong and had good intentions, their combined 300 or so pounds was not enough to offset Shelby’s 800 pounds of determination. Fortunately neither young man was seriously hurt and a few stitches was all they needed.

I worry that the current economic situation could involve a similar mismatch. While Congress keeps proposing one bailout plan after another, in the end there is no guarantee any of them will be able to get the economy back on track. It is particularly disconcerting that many analysts, economists and other experts keep mentioning that there remains a possibility for total economic collapse.

We have not experienced an economic collapse in this country so most people have no idea what that entails. I lived through the economic collapse that occurred in Eastern Europe prior to and after the fall of communism. It would mean most of the population out of work and many others working without getting paid. It would mean closed banks and stores with very little inventory. Daily life becomes a constant struggle to earn some money and to find food or other needed items. Those kinds of conditions endured for five or six years in Russia. All the while other countries were supplying aid and assistance.

Unfortunately, there won’t be anyone to give assistance to us if the U.S. economy fails. Much of the world is already in much worse shape and this crisis is a black cloud threatening every corner of the globe.

This is traditionally a time of year for optimism. Right now in spite of our political affiliations, we all need to hope that President-Elect Obama and the members of Congress can come up with a plan that can restore economic stability. While we can take some encouragement from a Santa Claus rally in the markets, risk remains extremely high and the best course of action is to remain on the sidelines.
F.S.

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Monday the National Bureau of Economic Research (NBER) formally announced that the United States is in an economic recession. While stocks dropped sharply the day of the announcement, it really wasn’t much of a surprise. It’s kind of like calling a press conference and announcing that the New York Giants won the Super Bowl. Everyone who is interested already knows.

In announcing its findings, the NBER noted that the U.S. economy peaked in December 2007 and has been contracting since then. The peak marked the end of the expansion that began in November 2001 and lasted 73 months. According to the statement from the NBER, “A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in production, employment, real income, and other indicators. A recession begins when the economy reaches a peak of activity and ends when the economy reaches its trough. Between trough and peak, the economy is in an expansion.”

While the official recognition of a recession is underwhelming, we might be able to glean some valuable information by comparing the current economic downturn to prior periods of economic weakness. For example, since 1945 the NBER has identified 10 complete cycles of contraction and expansion. On average, the contractions lasted 10 months and the expansions persisted for 57 months. Since 1854 there have been 32 cycles and the average contraction lasted 17 months.

These contractions do not directly coincide with stock market index peaks and bottoms. According to the NBER, the prior contraction began in March 2001 and ended in November 2001. While the equity market indexes peaked in early 2001, the stock market bottom did not occur until Fall 2002.

If something similar occurs this time, equity markets could continue to decline for many months after the economy begins to expand. No one knows exactly when this contraction (recession) will end, but it seems likely to persist until the credit crisis is resolved and until the global real estate market strengthens.

The longest contraction of the 20th Century was 43 months beginning in August 1929–a period commonly known as the beginning of the Great Depression. Since then the two longest contractions have each lasted 16 months. One began in November 1973 and the other in July 1981. I remember the latter particularly well because it coincided with my graduation from college.

The current economic situation seems much more dire than the turmoil of 1981. If asked to make a prediction, I would anticipate that this recession will last for at least another six to eight months. That estimate is based on things like Fed Chairman Bernanke’s comments today that more action is needed to cut mortgage foreclosures. It is going to take lawmakers a minimum of two or three more months to come up with substantive economic rescue plans, then a few months for those plans to begin to have an impact.

Continued market volatility is likely until there is substantial evidence that the economy has turned the corner.

If you would like to read the official announcement about the recession from the NBER, you can find it and a host of other interesting economic data at the NBER web site: www.nber.org
F.S.

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Because of the Thanksgiving holiday, I am not doing a market commentary this week. Please enjoy this time with your family and friends and forget about the world’s economic troubles for a few days.

F.S.

Back in mid-October, one expert after another was quoted in the financial media as saying that the worst was over and the best move for investors was just to hang on. In my weekly commentary, I wrote that from all the indicators I know of, there was no evidence that the markets had reached bottom.

In October, major indices never reached the lows set back in the 2000-2002 bear market. The last week of October the indices rallied and many of the experts who earlier said the bottom was in started saying “I told you so.”

Now it is my turn. So far in November, the market bias has been decidedly negative. And this week major indices surpassed the lows set during the 2002 bear market. I wrote a month ago that every technical indicator that I knew about was negative. That remains the case today.

Below is a chart of the price activity of the S&P 500 so far this year. I added a red line to show the technical support that the index failed to break through on prior attempts. The first time it reached that support in November, a strong one-day rally pushed it back above 900. But a week later the index has easily broken through that support and could freefall from here.

Normally I am not an advocate of short positions. Somehow it makes me uncomfortable and even a little unpatriotic to place a bet against American industry. Normally my short positions are reserved for hedging. But early in November I took a position in a fund that shorts the S&P 500.

It was the indicator in the middle section of this chart that convinced me. That section shows a moving average convergence divergence (MACD). I think the MACD is a pretty good tool for forecasting near-term market behavior. Notice the red arrow I added to the MACD. See how it only made it about halfway back to the zero level before it rolled over? That is a very negative sign.

The bottom section of the chart is a relative strength index (RSI). It faltered early in November when it reached the 50 level and could not break above it. That is also a negative sign.

By every technical, fundamental and cyclical indicator, this is a very powerful bear market that wants to go lower. The fact that Congress and Wall Street and virtually every investor in the world want it to reach a bottom and turn back up is meaningless right now.

Once again today on the radio I heard a commentator telling investors there is no need to panic they should remain invested in the stock market. He said that U.S. stocks historically average a return of 10% a year and that as long as investors stay in the market, they will quickly recoup their losses.

My three horses produce less manure than he was throwing around. Major indices are already approaching 50% losses for the year. So if his 10% figure is correct, it will take investors 10 years to recoup what has already been lost. (Do the math. It takes a 100% gain to make up for a 50% loss.)

But there are no signs that the markets aren’t going to keep dropping. How low can they go? A month ago I wrote that 600 on the S&P 500 seemed very possible. At the time the index was at 950. Today it closed at 752. Now I am thinking that there is a distinct possibility that it could fall as low as 500 before this bear market ends.

Rod Jackson is the chief architect of our managed investment strategies. A few days ago someone asked him about the next level of strong technical support for the Dow. He said he thinks 4,000 is possible.

Until we see dramatic increases in consumer spending and confidence and until corporations return to profitability, the only direction the market can easily go is down.

F.S.