Overdue Bounce

3/16/2009


Stocks have jumped off their lows in recent sessions, buoyed by good news coming from the banking sector and short covering. However, the market’s primary trend is still bearish under the Dow Theory. Thus, subscribers should view rallies with caution, keeping 30% to 40% of equity portfolios in a short-term bond fund.

Bear-market rallies
Stocks recently posted their largest one-day advance of 2009, with the Dow Industrials rising 379 points on March 10.

The rally was spawned, in part, by reports that Citigroup had operated at a profit during the first two months of the year.

While the rally is a welcome respite from the pounding stocks have taken over the last four weeks, investors need to keep such rallies in perspective. With the market’s primary trend still bearish, under the Dow Theory, rallies have to be viewed as bear-market rallies at this juncture.

A distinguishing characteristic of bear-market rallies is that they tend to be violent but fairly brief.

An example of a bear-market rally was the move that immediately followed the Dow Industrials’ decline to new lows on Nov. 20.
The Industrials rallied 20% to 9034.69 on Jan. 2 — a rally that encompassed 28 trading days. Unfortunately, the rally didn’t hold, with the Industrials breaking below the Nov. 20 lows in February and moving sharply lower in March.

To be sure, there are factors that could fuel a sizeable rally in the short run:

High degree of pessimism. Despite the recent bounce, investor pessimism remains high. As the chart on the right indicates, adviser bearishness is at extremely high levels. And the Intermediate Potential Risk indicator continues to plumb new lows. Strong rallies often spring from extreme pessimism.

Lots of investor liquidity. Some $4 trillion is sitting in low-yielding money markets. This reservoir of funds could provide plenty of buying power.

Still, because of the bearish primary trend, investors would be advised against chasing rallies. Yes, a bear-market rally can ultimately prove to be the first leg in a new bull market. But with the latest bounce showing the type of volatile action characteristic of bear-market rallies, the prudent course of action is to maintain a defensive position.

Conclusion
The market was overdue for a rally. While it is possible that any rally here could eventually be the beginning of the next bull market, investors would be wise to regard such rallies as bear-market rallies until the Dow Theory says otherwise.


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