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Bear Market Rallies

Just Another Market Head Fake... or a Secular Bear Market?

Written by Brian Hicks
Posted August 21, 2008

Make no mistake about it, a bull market is a lot more fun than a bear market. After all, in a true bear market the bulls take it horribly on the chin.

But that doesn't mean that a bear market can't provide its own share of excitement—even for the bulls. They call them bear market rallies, and they are usually enough to bring all of the bottom callers back out of hiding again.

The most recent rally is the latest example of what I'm talking about.

The Dow bounced 11.2% of its July 15 lows and bulls could barely contain themselves. In fact, with every 300 point rally they were convinced that the train was about to leave the station.

But what most of them either don't know or won't tell you is this: 300 point rallies in a bull market just don't happen.

In fact, in the bull market from October 2002 to October 2007 the market never rallied 300 points in a single day. Not once.

Meanwhile, those same 300 point rallies have happened 6 times in the current bear cycle and occurred 12 times in the last one. So much for the train that guys like Jim Cramer keep talking about.

Bear Market Rallies Meet Reality

But statistics aside, many investors still wonder what the real deal was behind it all. Was the latest market move to 12000 again just another head fake in a deeper bear market? Or was it something else?

To help answer that question we are going to play game I used to love as a kid. It's called connect the dots.

Of course, the picture we are dealing with is a bit fuzzy, but that's the way game is played. That is until we begin to connect those dots one by one. The picture gets more clear.

It begins where it all started—-in housing. And judging from the most recent data the bottom in the housing market is nowhere in sight.

Here is the latest:

· U.S. Foreclosures Rise 55%, Bank Seizures Reach High: "Banks repossessed almost three times as many U.S. homes in July as a year earlier and the number of properties at risk of foreclosure jumped 55 percent as falling prices made it harder to sell or refinance. Bank seizures rose 184 percent to 77,295, the steepest increase since reporting began in January 2005."

· U.S. Home Sales Fall to 10-Year Low as Prices Tumble: "Existing U.S. home sales fell to a 10-year low in the second quarter and the median price for a single-family house dropped 7.6 percent as the real estate recession deepened. The median tumbled to $206,500 from $223,500 a year earlier, the Chicago-based National Association of Realtors said today."

The Bottom Line: As long as housing remains in a free fall - and it will - there is no bottom to the bigger crisis. It's simple really - the banks can't possibly bottom until the housing market does. That's because every leg down in housing causes greater losses for the financials, which lead to further write-downs, dividend cuts, and ultimately, in some cases, insolvency.

But that's just the first set of dots in this picture so you need to read on:

· Banks' Subprime Losses Top $500 Billion on Writedowns: "Banks' losses from the U.S. subprime crisis and the ensuing credit crunch crossed the $500 billion mark as write-down's spread to more asset types. The International Monetary Fund in an April report estimated banks' losses at $510 billion, about half its forecast of $1 trillion for all companies. Predictions have crept up since then, with New York University economist Nouriel Roubini predicting losses to reach $2 trillion."

· Large U.S. Banks May Fail Amid Recession, Rogoff Says: "Credit market turmoil has driven the U.S. into a recession and may topple some of the nation's biggest banks, said Kenneth Rogoff, former chief economist at the International Monetary Fund. ``The worst is yet to come in the U.S.,'' Rogoff, a Harvard University professor of economics, said in an interview in Singapore today. ``The financial sector needs to shrink; I don't think simply having a couple of medium-sized banks and a couple of small banks going under is going to do the job.''

The Bottom Line: As banks crumble beneath the weight of all those loans gone horribly wrong, they will face a point of absolute crisis. In fact, somewhere out there today there is a whale or two struggling to stay afloat. Its business model is wrecked and it is loaded down with more debt than it can swallow. When one of these washes up on the beach, it is going to take the market down with it.

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The Next Dot is Inflation...It's Getting Worse.

  • Bracing for Inflation : "The relative price stability of the past 15 years is giving way to worsening inflation, despite the recent softening of oil prices. The Consumer Price Index for all items shows the inflation rate averaged 2.6% a year from 1992 through 2007 but has doubled since January, reaching an annual rate of 5.6% in July (BusinessWeek.com, 8/14/08). By next year, the monthly figure could hit double digits, and the inflation rate for 2009 overall could triple 2007's 2.85%."
  • U.S. Producer Prices Surge: "Prices paid to U.S. producers rose twice as much as economists had forecast in July, reflecting the jump in energy and commodity costs that has since started to wane. Producers paid 9.8 percent more for goods from July 2007, the biggest year-over-year gain since June 1981, compared with a 9.2 percent gain in the 12 months ended in June. Excluding food and energy, the increase was 3.5 percent from a year earlier, its biggest jump since 1991, compared with a 3 percent gain in the prior month."

The Bottom Line: When the Fed rushed in to save the banks with big interest rates cuts (3.25% in 12 months) and bailouts, it set off bout of inflation that amounted to the final straw for the economy. The dollar dropped, and prices went into another universe. And while the ultimate end game is likely deflation, for now it is skyrocketing prices that have to be dealt with. That's helping to stall the economy.

· U.S. Economy: Jobless Rate Rises to Four-Year High: "The U.S. unemployment rate rose to the highest level in more than four years as employers cut jobs again in July, increasing the threat of a deeper economic slowdown. The jobless rate rose to 5.7 percent, from 5.5 percent the prior month. As recently as April, it was 5 percent."

· GDP fell in Q4 2007, first drop since 2001: "The U.S. economy shrank during the closing months of 2007 for the first time in six years, the Commerce Department confirmed on Thursday, hurt by the steepest slump in housing since 1981. The department sharply revised its estimate for fourth-quarter performance to show gross domestic product, or GDP, contracted 0.2 percent — rather than growing 0.6 percent as it previously reported. It was the first three-month period in which GDP shrank since during the last official recession when growth contracted by 1.4 percent in the third quarter of 2001."

The Bottom Line: A combination of higher prices, rising unemployment, and a recession have put the American consumer on the ropes. And since consumer spending accounts for 72% of U.S. GDP, the economy is about to go the mat.

Unfortunately, when you add it all up it has created a negative feedback loop right back to where it all began... housing. That makes for further down side as weakening economy and job losses drag housing down the next leg. In short it's a vicious cycle.

The next set of dots is a consumer-led recession, the first since 1991. That's the last leg of the game and it promises to be the most difficult.

Of course, there are many other dots out there but at this point the picture is crystal clear. We are in a secular bear market. Rallies within them are to be expected.

But don't tell that to the perma-bulls they're busy trying to catch trains to nowhere.

In the meantime, it is a trader's market all the way.

Your riding-the-waves analyst,

steve sig

Steve Christ

Investment Director, The Wealth Advisory

PS. Making money in a bear market is tough, but it can be done. Since the first of the year The Wealth Advisory is 11-5 in its closed positions with a cumulative gain of 290% vs losses of only 55%. That is a net gain of 235%.

To learn more about The Wealth Advisory click here.

By the way: An alert old sailor was quick to point out the errors of my way last week when I wrote that John McCain finished at the bottom of his class. That was a bit of an overstatement. McCain actually finished 894 out of 899 midshipmen that year. I stand corrected, sir. Thank you for your service. To learn more about Sen. McCain's days in Annapolis click here

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