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Stock Market Correction or New Bear Market?

Stock-Markets / Stocks Bear Market Feb 24, 2010 - 05:50 AM GMT

By: Money_Morning


Best Financial Markets Analysis ArticleJon D. Markman writes: With U.S. stocks down about 5% from their 2009-2010 rally peak, investors basically want to know one thing: Is this just a correction, or are they looking at a potentially long bear market?

That's no small question. U.S. stocks could be experiencing one of three scenarios at present. They could be:

  • Undergoing a short-term "correction" of its 2009 gains.
  • Beginning a multi-month "pause."
  • Or starting a new bear-market cycle.

These aren't just arbitrary labels. For instance, a typical "correction" lasts but a month or two, with average declines of 8.5% to 10% on the Standard & Poor's 500 Index. A multi-month pause, by contrast, could last eight to 15 months, and involve an S&P 500 decline of 10% to 18%.

But a new bear market is an entirely different animal. A bear-market cycle could last as long as two years and could be marked by a decline of 20% or more.

A Look at the Past

I've been arguing the case for a multi-month pause that lasts until around October, and that concludes with the S&P 500 down around 950 - a 17.5% drop from its Jan. 19 peak of roughly 1,150.

As Money Morning readers will recall, I arrived at this conclusion after studying many prior periods similar to the present, including 2004, 1983-1994, 1971, 1934 and 1910. Each of these periods followed huge run-ups in stock prices, and featured prolonged periods during which stocks were either locked in a protracted sideways trading pattern, or suffered a long and painful decline.

In each case, stocks subsequently retraced a portion - but by no means all - of their fantastic prior advances.

By the time these multi-month declines have ended, you can be sure of one thing: The so-called new "market bottoms" become very tough to believe. As each "bottom" is first set, and then blown through, investors find themselves wondering: Just how low can stock prices go?

Sniffing Out a Real Rebound

By the time the correction/bear market runs its course, participants will be absolutely worn out by repeatedly seeing their expectations for a quick recovery dashed.

What will typically occur first are probes back toward overhead resistance levels - in the current case, that would be the 1,120 area of the S&P 500 - that fail at successively lower levels. And each of those are followed by probes lower that recover at successively lower levels.  

But what if this scenario is wrong: How will we tell?  

First of all, the main refutation of the multi-month correction would be a move higher in the next week or two that closes above congestion at 1,120. That's 11 S&P points higher.

If there are a couple of closes above 1,120, we would see furious resistance there from bears and they could mount a successful defense. And then the final refutation would be an advance back above the 1,150 level last seen on Jan. 19.  

Among the analysts who foresee that scenario is money-management researcher Birinyi Associates, which points out that the average postwar correction has lasted 45 days and concludes 8.5% below the peak - roughly where we are right now. Birinyi is joined by strategists at Morgan Stanley (NYSE: MS), who recently told Reuters that "our hunch is that markets will recover their poise, and investors will be able to sell at higher levels than now."

For another defense of a bullish posture, let's turn to Florida's Lowry Research Corp., publisher of Lowry's Reports. Lowry's is one of the oldest technical-analysis shops in the country, owns one of the best databases of market price-and-volume data, and has spent decades conducting pioneering research on bull- and bear-market cycles. Paul Desmond, head honcho at Lowry's for more than a decade, told his institutional clients on Friday that every bull market has at least one pullback that fools investors into thinking a new bear market has begun.

To create this deception, Desmond says these pullbacks need to be severe enough to raise expectations that a new bear trend is under way - something that we might expect to see occur with a correction of 10% or more. But to be deceptive, declines like this should be relatively rare occurrences, which runs counter to the general perception among investors that 10% corrections are normal events in bull markets. However, Desmond's study of his firm's 77-year-deep database calls this assumption into question.

"Since the 1942 market bottom, there have been 16 bull markets in the Dow Jones Industrial [Average]," Desmond says. "Of these, only nine have shown corrections of 10% or more. And there was never more than one 10%-or-greater correction in any one of these nine bull markets. So rather than being commonplace, pullbacks of this magnitude are relatively infrequent. As such, it is possible to see how they could be interpreted as the initial phase of major-market declines. This would be especially true when the correction occurred at the mid-point or later in the bull market, as was the case in six of the nine sell-offs."

Desmond then asks the rhetorical question: How are investors to differentiate between these corrections and the beginnings of a new bear market?

"One similarity in each of these cases of corrections reaching 10% or deeper is that they typically occurred well into the second stage of the bull market," Desmond says. "That is, profit-taking has already been well established, as reflected in a sustained uptrend in selling, thus setting the stage for deeper than normal corrections. In the present case, however, our Selling Pressure Index was recording an 18-month low in mid-January when the market correction began. Thus, based on the long history of the Lowry Analysis, the probabilities do   not   favor a 10% plus correction occurring at this relatively early stage of the uptrend."

Bear-Market Risks Easing?

On the contrary, Desmond says that he sees "a growing body of evidence" to suggest that the recent correction may have already ended.

"Many short-term corrections end with a small selling climax at or near the market low, as evidenced by a 90% Downside Day, as recorded on Feb 4," he said. And a recent rally "caused virtually all of the major price indexes to break above trend lines that can be drawn downward from their Jan. 19 highs. Similar breakouts above down-trend lines can be seen in all of our advance/decline lines."

He goes on to point out that probabilities are not certainties, and allowance for exceptions to the probabilities is always necessary. But it is important to keep in mind that, with the S&P 500 down about 5% and the Dow down about 4% from the mid-January highs, the issue is whether the short-term correction may not be quite over, yet, or whether it is already over. In either case, based on his longer-term measurements of supply and demand, Desmond says there is little evidence that the market has rolled over into a bear market.  

The upshot: "Investors should still be viewing periods of short-term corrections as an opportunity to buy strong stocks in the strongest sectors and industries," Desmond says. "A strong rebound from the recent market low, characterized by rising volume, would tend to confirm that the correction has run its course and has returned to the primary uptrend. If that occurs, then a deeper 10%-plus correction, if it occurs at all, would be an issue for a later day."  

Now - for better or for worse - you know the technical advice being read on institutional trading desks.

In closing, we are presently stuck in a no-man's land, which is a very difficult place to establish major new positions. The bulls appear to be regaining control, but now it's time for them to prove it. I will feel comfortable recommending "short" positions if bulls fail here. So stay long for now, but prepare to change uniforms to fight with the shorts if bulls lay down.

Source :

Money Morning/The Money Map Report

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