Option Investor
Trader's Corner

Bad News Bear

Printer friendly version

You know you're in a bear market when talk of Government and Fed action ('happy' talk) no longer buoys the market. Of course there was more than that today with news on more write downs by Banks, Merrill's reported loss (even though widely anticipated) and a 16-year low in U.S. housing starts as part of the jolly news. No, I'm talking about the anticipated further Fed rate cuts coming, which in our not forgotten and recent bull market past, would have been enough to rally the market; that, and talk of anticipated action for a government stimulus package.

The difference is that we're probably in the throes of the second stage of a bear market as I wrote about in my last week's Trader's Corner (1/9) article. These stages, as originally observed by Charles Dow well over a hundred years ago, being:

1. Distribution (selling) of stock.
Selling near the top and on major rallies especially by insider types and astute fund managers who did what most investors DON'T do and who looked at the market with a FRONT-VIEW mirror instead of the typical 'rear-view mirror' view. The rear view mirror view is the habitual response that stocks will keep getting driven by the same economic and earnings growth that drove equities higher in the months and years beforehand.

2. Panic selling.
That's the phase were in now folks. Actively selling as well as disinterest or fear in stepping in to buy. There is a greater conviction dawning that the economy has entered either a period of slowdown or gone into recession. Here is where belief in investing for the 'long-haul' and not concerning oneself with the month to month, quarter-to-quarter downturns, starts to get tested.

3. Discouragement.
We have seen the beginnings of this, but only the bare beginnings. This phase tends to get more pronounced as time goes on without a lot of encouraging news and by the fact that rallies don't carry that far or for that long.


Now for the good news or somewhat encouraging news. I wrote about something called the 'DECEMBER LOW' rule this past weekend in my column appearing in our online Index Trader section.

The Stock Traders Almanac points out a pattern that suggested we would get the bear trend we're in. This relates to the historical record for when the prior December low is pierced in the first 3 months (Q1) of a new year as has happened of course; in terms of the Dow Jones Average (INDU), when INDU closed below the December 13167 low on January 2nd.

What this is about is an observation made over a long period that when the Dow closes below its December closing low in the first quarter, it is has been frequently a warning of a substantial further decline to follow. Lucien Hooper, a Forbes columnist and Wall Street analyst originated the 'December Low' indicator in the 70's. Hooper dismissed the importance of January and January's first week as reliable indicators. He noted that the trend could be random or even manipulated during a holiday-shortened week. Instead, said Hooper, "Pay much more attention to the December low. If that low is violated during the first quarter of the New Year, watch out!"

This is not to say that the market was then in trouble ALL year. In fact, 13 of the 27 occurrences where the December low was pierced were followed by gains for the rest of the year and gains for the full year, after the low for the year was reached. But, Hoopers 'watch out' warning for FURTHER declines was quite correct. All but one of these instances since 1952 saw further sell offs after the first low(s). In terms of the Dow, there was an additional 10.1% decline on average when the prior December low was pierced in Q1. Only 3 significant drops occurred when Decembers low was NOT pierced in Q1 (1974, 1981, and 1987).

OK. If we take today's close in the Dow at 12159 and use this over-rated (and narrow), but most widely followed Market average, as our benchmark, INDU has already declined 7.6 percent below its December closing low of 13167. If the average decline of 10.1 percent (below the December low) is the worst that is in store, and of course it could be more, could be less, we would expect to see a further decline to a Dow close around 11838. Which is only another 321 points; given today's drop of 341 points, we're only a day away! Well, I figure that we may be closer to at least an oversold rebound than thinking that we'll fall another 300+ points straight away for some technical reasons I'll lay out next.

Since I'm discussing the Dow here and using this our benchmark, I'll also say that, while a narrow index of only 30 stocks, this average does tend to trade very 'technically'. By this I mean that INDU tends to trade in fairly predictable chart patterns. For example, the long-term weekly Dow chart below has a well-defined uptrend channel. The 2006 weekly lows that are highlighted at point '3', represented the 3rd. major low defining a long-term up trendline dating from the 2002 bottom. The upper channel line, drawn parallel to the rising up trendline and touching the early-2004 high, was uncanny in predicting the area where the two major highs would occur last year.

IF intersection of the a possible point 4 on the long-term up trendline around 12070 were to act as a next technical support, then we could expect to see a rebound from at or near today's low. Stay tuned on that! As to whether any near-term rebound will carry much higher or for long, that's another question.

Judging by the 13-week RSI, INDU is already as 'oversold' as it's been in years. However, since bear markets, assuming that's now what we're in and I think we are, act differently in terms of oversold, we could see this indicator do the reverse of the highlighted RSI pattern in late-'06 to early-'07, when INDU got 'overbought' and then STAYED overbought. A lengthily oversold period ahead, registering a low RSI would be typical of a major bear trend.


Just as traders get, and stay, quite bullish in a strong rising trend for stocks, my indicator of call to put activity is starting to register multiple readings suggesting a strong bearish outlook, according to my 'sentiment' indicator seen next on the daily S&P 100 (OEX) chart.

In a bull market trend or in a trend that is still PERCEIVED as in a predominate bull trend such as in the August-November period (see highlighted circles below), it only took ONE or at most two dips of my sentiment indicator into the 'oversold-extreme bearishness' zone seen in the lower portion of the daily OEX chart below, for a rally to then follow soon thereafter; i.e., within 1-5 trading days. Recently, we've seen THREE days at or below the level on my sentiment indicator where I would normally anticipate an upside reversal to be coming soon.

However, we now have to skew interpretation of my sentiment indicator to account for the conditions of a major bearish trend. While a rally coming up soon shouldn't surprise us, it's has (and should in the future) taken a more prolonged period of bearishness to 'set' up such a rally.


Not everything currently matches up in technical terms, especially when you have diverging trends in the Nasdaq relative to the major indexes that contain mostly NYSE stocks; e.g., the S&P. The 2007 super-strong Nasdaq 100 (NDX) would have to decline all the way (from today's 1842 close) to around 1700 to ALSO get back to ITS long-term up trendline. If this happened, all the other major index up trendlines would have broken down before this.

As to NDX, it's usually more realistic to compare the benchmark Nasdaq Composite (COMP) to the leading indexes measuring the NYSE market. And by that measure, COMP started to fall out of or below the low end of its weekly long-term uptrend channel today. However, if COMP rallies tomorrow, the index can still easily CLOSE within the uptrend channel highlighted below. The Composite is also getting finally into the area that marks the beginnings of a major oversold condition per the 13-week RSI.

The last thing to state as regards the ability for the major indexes to maintain their long-term UP trends, is that such bullish up trendlines can and do get pierced or broken in a major bear trend. We probably have lower to go all the way around, but so far some major up trendlines are holding or could still remain mostly intact. I'm waiting to see if the other shoe drops later, even if we get a short-term rebound developing soon. If there's significantly more downside to come, the target for the Composite may be down toward the 2000 area again.


Trader's Corner Archives