Bear Rally Sets up Greater Decline in 2002

After a ferocious year terrorizing traders on Wall Street, the great bear has taken a temporary hiatus, and buyers have been allowed to mark up prices in the first significant rally in several months. This rally will prove fatal to many traders as they will be certain the bull market has returned -and will plunge their lines back in with reckless abandon, only to be mauled by the returning bear early next year. An old saying on Wall Street is that bear market rallies can be vicious to the upside, but they are equally brutal when once they finally reverse. The bear is going to own many a trader's wealth in 2002.

The dominant interim cycle is the 40-week cycle and it bottomed around October 1. The sub-dominant cycle also bottomed at this time, so both cycles are currently in the "up" phase, which means there is a bullish cyclical bias in the market's favor. There will be pullbacks along the way but the overall thrust of the market in November should be up.

A few weeks ago we compared the plight of the market right now to the fall of 1998, and it now appears we were correct in this analogy. Just like in 1998 when the Dow bottomed at a critical support level on extremely high volume, then rocketed to higher prices as the Federal Reserve was cutting interest rates, we see a nearly-identical repeat this year. Take a look at the chart from 1998 and compare it to today's Dow. The only difference is that the rally of late 1998 occurred within the context of a bull market. To be sure, this year's rally is within the context of a long-term bear market. We noted earlier the extraordinary amount of buying volume that came in around the mid-September bottom. And this ensures there is plenty of 'fuel' for the Dow to keep going forward awhile. Remember, volume must be thoroughly exhausted before a major reversal can begin -- and we are not there yet.

The vigorous nature of the current rally should not be surprising, since it represents pent-up demand from stock traders since last year. There is still much latent bullish sentiment among today's traders. Investors and this buying urge must be served before the decline can resume full force. Harry Schultz, in his book "Bear Markets: "How to Survive and Make Money in Them," writes, "In bear markets, stockholders are anxiously awaiting the return of the bull tide; they are eager to seize upon any rally as the 'turn.'"

Since the current rally began at oversold levels on extremely high volume, we must expect more time before the volume and momentum are completely exhausted and the trend turns down again. All in all, the Dow should end the year on a positive note, just as we predicted at the beginning of the year because 2001 is the alternate year in the 2-year cycle. Also, this year represents the first true 'rally year' in what should be a multi-year bear market - and the rallies in the early phases of a bear market tend to be very pronounced, even to the point of fooling people into thinking the bull has returned.

Many traders believe that this rally represents a resumption of the bull Market, but this is not the case. This is true because even the bulls themselves will help to facilitate the reversal once prices reach a point to where traders who lost money in the last down leg can recover a substantial portion of their losses… and where buyers want to take a profit. Schultz describes the psychology of bear market rallies this way: "As prices rise to retrace about half the fall, traders will begin short selling again, and those who bought at the recent bottom will see nice profits, which they will begin to take, and those who have done nothing since the bear market started will see prices returning close to their cost price, so some begin to sell, willing to take a small loss in many cases. Since the public confidence was shaken by the prior down-move, there will be few who will wait to see how far prices go; they will take a relatively reasonable price for their stock while they still can."

A bear market rally can be likened to an inflatable mattress that is being deflated too quickly. At some point, due to the uneven distribution of air within the mattress, the pockets of air must be smoothed out and gathered together in one place in order for air to flow evenly out of the mattress again. This causes a bulge in a corner of the mattress, which, to someone who doesn't know any better, would assume the mattress is actually being inflated rather than deflated. But the bulge will soon be deflated, once enough air has been amassed to let out. In the same way, bear market declines often exhaust themselves, temporarily due to excess short covering, volume drying up, etc. In order to "correct" for this, the market temporarily re-inflates (i.e., rallies), sucking in money that has been unevenly distributed and re-liquefying the market. To the untrained observer, this appears to be the start of a new upward trend, BUT it is actually a 'set-up' for yet another drop in prices. What we are now witnessing in the market is this very phenomenon taking place.

The coming weeks and months will present some of the most fabulous opportunities for quick profits in several decades, even more so than the preceding bull market. The early stages of deflationary bear markets are like that -- the trick is knowing where to be at the right time, and that's our specialty at The Bear Market Report.

Hang on tight for a spectacular Year 2002. The best (for the bears) is yet to come.