Bear Market Rally Nearing Completion

The last two months in the U.S. equities market have been nothing short of nerve wracking, especially for investors of a bearish mindset (as we have maintained throughout). Shorts positions were forcibly covered, put options were killed, large sums of money lost and all of it attributable to a bear that we at first heartily welcomed and thought to have befriended. As we all have painfully learned, however, the bear is nobody's friend - and only through careful, almost excruciating effort can profits be made in his presence.

However, there is light at the end of this tunnel (harrowing as it has been to navigate). While we may have lost much of the profit we gained in the initial phase of the Wall Street sell-off, we are almost assured of getting it back—probably sometime this month. The meteoric rally from last month's Fed-initiated interest rate cut has done much to disorient even the best of market technicians and financial advisors. We confess to ourselves being made dazed and confused by the early explosive part of the move and only recently did we become reoriented. We can now assert with reasonable assurance that the first intermediate bear market rally is nearly complete. In fact, it would not surprise us to see it end as early as this week (and with several events of major significance scheduled to take place this week, we have more reason for believing this—more on this subject later).

We embraced a short (very short) term bullish stance in last week's letter based on the undeniable bullish undercurrent in all the major U.S. indexes.

Looking at the charts, it was almost impossible not to be bullish last week based on the technical patterns and market internals -- and last week signified the first time in over a year we were officially bullish the U.S. stock market. In retrospect, perhaps we were a bit hasty in declaring the underlying bullishness in the market as strong enough to carry us through the remainder of 1998 - because clearly (as we see it now) that is not the case. In fact, we doubt we will exit the month of November in this bullish frame - and are now officially reinstating our bearish stance. All recommendations for individual stocks (namely the "blue chips" of the Dow) made in last week's issue should be disregarded at this time (although some of them did see a profit from last week until the present). Short positions should be gradually entered this week and rapidly entered as the technical picture begins to clearly deteriorate. We don't want to rush into bearish positions when some upside potential still remains, but we definitely don't want to be caught unprepared.

To begin our technical analysis of the market we will reassert our belief that the former all-time high in the Dow Jones Industrials of 9367 may be reached before the bear market recommences. In fact, based on the minimum measuring implications of the "mast" of the latest flag pattern to appear in the Dow's chart 9100-9300 is the least that can be expected. This does not guarantee this target will be reached (failures can occur at any time along the way) but it seems probable from here.

From an Elliott Wave perspective, it is becoming clear that the fall from July 21 until August 28 was a five-wave impulsive move that constitutes primary wave one, with primary wave two underway as we write this. Under the Elliott Wave theory, a wave two may technically retrace as much as 100 percent of the previous wave one. That appears to be the case here, especially as every other major Fibonacci retracement level has already been surpassed. Thus, we expect a total retracement of the decline from this summer reaching all the way to about the all-time high level of 9367. This is the absolute maximum level we expect to be reached by this current rally.

On all the charts we analyze of the Dow (cash and futures), including line charts, bar charts and candlestick charts, what is shaping up to be a clearly defined "rising wedge" pattern is forming. This is typical of bear market corrections, especially during the first major correction after the initial decline. They are typified by the extreme up-pointed slope, usually develop very rapidly (as this one has), gradually trace out an ever-contracting pattern (thus forming the "wedge") and are accompanied by diminishing volume as prices near the apex of the wedge. All of the characteristics just described here have been evident during the formation of this rising, or ascending, wedge. This week, particularly, volume contracted noticeably from the beginning of the week until the end. Clearly, we are almost at the end of the runup. When prices finally break through the tip of the wedge, the ensuing decline tends to be swift and deadly. There is no doubt in our minds that when this wedge is finally "broken" a sell-off will ensue, but of what magnitude we are uncertain. The least that can be expected from here would be a target of DJ 8300 based on the measuring implications of the wedge. However, if we are to see a crash in 1993, this would be the most likely time for one to occur (if we're going to see one at all), especially as the next impulsive move of this bear market will be primary wave three, the wave in which most crashes have historically occurred.

A crash, or at least a significant sell-off, would be exactly the way the bear would hope to catch the most people off-guard. With the historically volatile (and frequently dangerous) month of October behind us, a serious stock market decline is the farthest thing from most investors' minds as we head into the happy-go-lucky Christmas season, a time which most investors associate with a bullish stock market. From the bear's perspective, this would be the optimal time to make another grand appearance as he would certainly catch the greatest number of investors unprepared. (As ridiculous as all of this may sound, it is very prudent and necessary to think in terms of "the bear" when analyzing a market such as this one—bears specialize in catching as many people off-guard and unprepared as possible and the ultimate goal of any bear market is too wipe away as much liquidity as he possibly can).

The chart pattern says it all—the bear market is still here and we most definitely have not entered a new bull market. There really is no further need to analyze the market internals at this point—that's how confident we are in our assertion. But for what it's worth, market internals, while still technically bullish, saw gradual diminution of strength throughout the week. As of this writing (Nov. 13) market breadth was pretty much even by week's end and the number of new highs versus lows was starting to contract on the NYSE while it was negative on the NASDAQ and AMEX. Both the ARMS index reading and the CBOE put/call ratio were sending negative signals last week (and these indicators are especially helpful for calling turning points in the market). We still expect some bullishness during the current week (Nov. 16-20) but we suspect this will be the last time this month we'll see it. If our calculations are correct, the bear should be back in town by the week of Nov. 23 (if not this week). In fact, Wednesday, Nov. 18 would be a spectacular time for him to make an appearance in time for the Leonid meteor showers (significance?).

Tuesday, Nov. 17 also holds significance as the Fed will make another interest rate announcement (though it is anyone's guess as to whether they will leave rates unchanged or lower them—but it really makes no difference either way). So in more ways than one, the present week is shaping up to be one of great importance. We'll know more, of course, by next week's issue whether our present scenario is on track or merely illusory.