Bear Making itself Right at Home

The long-awaited bear market has finally arrived. While not making its presence known in singular fashion as we might have expected, it nonetheless has given us every indication that it has wandered into the U.S. equities market and has no intention of leaving anytime soon. It appears to be making itself right at home.

The broad-based decline in all the major U.S. stock indices last week was of course one measure of the bear's presence. And of course, the ongoing fall in small-cap indexes such as the Russell 2000 provides further confirmation that he is among us. Meanwhile, foreign markets are experiencing the ravages of the bear right along side of us, (though many countries are feeling its strength more than we are at the moment). The great Russian "bear" is in the midst of a most dreadful bear market as both its currency and its stock exchange plummet precipitously and rock the country's economy and its socio-political landscape. Dreadful though this may be, it pales in comparison to the threat currently faced by Japan as its Nikkei stock index continues to plunge, falling beneath two crucial support levels in as many days (the Nikkei broke the benchmark 15,000 level as well as the even more important 14,000 level last week. The index now hovers around 13,990). In the case of Japan, it cannot be emphasized the gravity of its predicament. What happens to Japan happens to all of Asia, and by extension, nearly all of Europe, parts of Latin America, and of course, the United States. Japan is literally the hub of the entire global economy and it now hovers precariously close to an outright meltdown which would carry the economies of the industrialized nations of the world with it.

Turning our attention to the U.S., the Dow Jones Industrial Average fell nearly 600 points over a three-day period last week and registered the third-biggest one-day points decline in its history (down 357 points on Thursday, Aug. 27). The Dow's drop carried with it the Transportation index, which fell below the 3000 level for the first time since last October's mini-crash (the index stands at 2827 as of this writing on Aug. 28). And the Nasdaq stock index of technology-weighted shares fell even more dramatically to 1635 by week's end, wiping out over 10 percent of its capitalization in only a one week period.

Market internals were horrendous. The advance/decline ratio on the NYSE was, on Thursday alone, nearly 8-to-1 (eight declining issues for every advancing one). All the major indexes fell below their 200-day moving average, a key psychological benchmark. And mutual fund shares, as measured by Investor's Business Daily's Mutual Fund Index, fell off steeply last week and have now trended below their 200-day moving average for over a month.None of this bodes well for the near-term prospects of the U.S. equities market or the general economy.

In fact, according to data released Aug. 28 by Fidelity Investments and T.Rowe Price Associates, U.S. investors in the month of August pulled out more cash out of stock funds than they pumped in—the first time in months that has happened. According to Fidelity, investors in August withdrew a net $1.8 billion from stock funds, compared with a net inflow of $900 million in July. This sharp curtailment of mutual fund flows ensures a decline in the stock market as the U.S. market has relied almost exclusively on mutual fund inflows to keep the bubble alive over the past year. More importantly, this change in investor sentiment from an insatiable "buy" mentality to a more cautious stance indicates a turn in investor psychology, a turn that will eventually bring the realization to the masses of investors that stock valuations are unrealistically high and should therefore be avoided. This mass realization will bring the U.S. stock market bubble to an inglorious end.

From an Elliott Wave, the Dow has now completed its first full intermediate "wave" down of its nascent bear market and registered its first "a-b-c" correction earlier last week to finish intermediate wave two. Wave three began with last Wednesday's (Aug. 26) fall of 81 points and continued with Thursday's 357-point drop and today's (Aug. 28) 114-point fall, to finish the week at DJ 8051. Based on our technical work, we expect the market's decline to continue into next week before its next "a-b-c" correction is registered. At the very least, 7700-7800 seems like a reasonable near-term support target before the Dow's next correction.

Based on Gann studies, however, we cannot rule out an even greater decline in the Dow before its latest fall is halted. Robert Krausz, president of Fibonacci Trader Corp. [tel. 512-443-5751] and author of the book, A W.D. Gann Treasure Discovered, has kindly provided Leading Indicators with Gann swing charts of the Dow's weekly and daily price trend. Based on Krausz's Gann and Fibonacci analysis, the Dow has support levels at DJ 8181 (a .618 retracement of its rise from January 1998 through July), DJ 7863 (a .50 retracement of the Dow's rise from April 1997 to July 1998), DJ 7447 and DJ 6975. It is entirely possible that either the 7447 or the 6975 support zones could be the levels at which the Dow meets with its next intermediate-term correction.

We again urge investors who have not already done so to consider entering positions in "bear market" hedge funds such as the Prudent Bear Fund (888-778-2327), the Rydex Ursa Fund (800-820-0888), or the Potomac OTC Short Fund (800-851-0511). The latter has thus far performed exceptionally well and was the number-one rated mutual fund last week. The fund is negatively correlated to the Nasdaq, and since the Nasdaq has suffered most heavily during this latest bout of decline, it has afforded its shareholders with the largest gains (and should continue to do so considering Nasdaq's extreme overvaluation). [Note: Leading Indicators does not hold positions in any of the aforementioned funds, nor are we compensated by them.] For conservative investors with large cash holdings, we recommend money market mutual funds and holdings of short-term U.S. T-bills.