Going against an established trend is rarely a good idea, but when you have a confluence of factors indicating that a top may be imminent, it's a good idea to pay attention. Currently we're at just such a confluence. Let's take a look at these factors one by one.

• The S&P 500 has bumped up against a critically important resistance level: the 50% retracement of the bear market. Think 50% is just another number? Think again ! Traders watch 50% retracements like hawks. Consider that the three-year decline stopped within 8 points of exactly 50% of the S&P 500's all-time high.



• More recently the stock market has been struggling with the 50% retracement of the bear market for the past few weeks. The level stands at 1161 for the S&P 500. (For simplicity's sake, I'm using round numbers). On its first test of this level the market backed off from a high of 1155. Last week, 1159 marked the high. Indeed, 50% is more than just another number.



• Last summer the S&P 500 broke out from a long-standing basing area between 769 and 965. Classic technical analysis forecasts a breakout move equivalent to the width of the basing area. In this case, that's 196 points which brings us again to the technically significant 1161 level (965 + 196). This bull market has thus achieved its upside objective and done so by reaching a "doubly-important" resistance level.



• Classic Dow Theory states that the Dow Transports should confirm the action in the Industrial Average. The Transports topped out a month ago and have since fallen sharply while the Industrials posted a new high just the other day. The failure to confirm stands as a bearish warning.



• I prefer an updated version of Dow Theory that demands confirmation between the more widely-watched and relevant S&P 500, Dow Industrials and Nasdaq Composite indices. And here we have yet another potential failure to confirm.



• While the S&P 500 and Dow have been flirting with new highs as recently as this past week, the Nasdaq appears to have topped out in late January and now stands perilously close to violating the critical 50-day moving average. While the uptrends in the Dow and S&P are still technically strong, the Nasdaq is in danger of rolling over into a short-term downtrend. Should it do so, the divergence will be confirmed, thus flashing a very bearish signal.



• Recent action at the highs in the S&P 500 and Dow suggest that buyers have run out of steam and that sellers are taking control of the market. In a healthy uptrend we expect increased activity and bullish enthusiasm at new highs. Bullish action should bring in new buyers. Instead, this past week we saw the market probe into new high territory and then reverse sharply. The absence of buyers emboldened sellers who appear to be taking to the task with a vengeance.



• Bullish sentiment is at major extremes. Market Vane Bullish Consensus recently reported that 70% of market advisors are bullish. That's a two-year high and it stands well above the 61% reached in January of 2000. You remember 2000, don't you? That was when the biggest stock market bubble in history finally topped out and sent the Nasdaq skidding more than 80% while the S&P 500 lost half of its value over the next few years. And today market advisors are even MORE bullish than they were when the bubble topped out!

Individual investors are not any more rational these days. The AAII reports that 61% are bullish, well above the 47% observed last year. In terms of mutual fund inflows, that translated into $40.8 billion in January. Individual investors have once again grown recklessly bullish, throwing record amounts of capital at the markets. Sound like an emerging, healthy bull market to you?

Individually, none of these factors are necessarily significant. We've seen divergences before in this mini-bull market. We've also seen extremes of sentiment persisting for some time. And yet the market continued marching onward to new multi-year highs.

What's different this time? The confluence of factors: all the bearish ducks are lining up in a row. The S&P 500 is trading at excessively high valuations typical of bull market extremes while bumping up against a hugely significant technical resistance level: 1161. If there's a good place for the market to back off from, this is certainly it! All the while, market sentiment is at extremes, most everyone is bullish but we're seeing large divergences between key indices.

Does this mean we're most certainly witnessing the formation of a major top? Not necessarily. There are no certainties in this game. But I believe that we're still in a primary, long-term secular bear market. Within that context, 50% counter-trend moves are not unusual nor do they signify the emergence of new bull markets. Today we find ourselves at a critical juncture that stands a very good chance of marking the end of the secondary, countertrend "mini-bull" market and the resumption of the primary, long-term bear market.

For those who still insist that the past year's bullish action is indicative of a newly emerging bull market, I leave you to ponder the words of Frank Veneroso.

Vernon Smith, a recent Nobel Laureate in behavioral finance, has provided evidence that, when bubbles burst, there follows a rally which is an echo of the bubble. In the echo bubble rally psychology remains more or less the same as what it was at the peak of the prior bubble, despite the pain of the intervening bear market. Smith's evidence indicates that psychology does not truly change until the echo bubble bursts. Only then does the market revert to a semblance of rational pricing.

Have we witnessed the bursting of a bubble? Absolutely. Is current market sentiment the same as at the peak of the prior bubble? Absolutely. Is this an echo bubble? It certainly appears so. Will it burst? Count on it.

Mark M. Rostenko
Editor
The Sovereign Strategist

February 21, 2004

Mark M. Rostenko, a veteran of Chicago's commodity exchanges and editor of The Sovereign Strategist, spends far too much of his time enthralled by the never-ending procession of inane prattle emanating from Wall Street. Nonetheless, it hasn't stood in the way of accurately forecasting the dollar's top, the beginning of the gold bull market, and nearly every significant turning point in the stock market since the bear market began. Please visit www.sovereignstrategist.com for a free sample issue and more commentary. And while you're there, feel free to join our international family of well-informed and successful investors.