The Nature of Bear Market Rallies

March 12, 2002

A subscriber asks, "If the Dow manages to climb above 12000 wouldn't this mean a new bull market has begun? We're not that far away from that level." Technically, we're not too far away from 12000 but it would take a considerable amount of buying to push the Dow that high, a feat we deem unlikely. In order for a new bull market to be underway two things must happen:

  • The Dow must be above 12,000 after the first week of June, or
  • The 40-week cycle, which bottoms around the first week of June, would have to bottom above Dow 10,300, which is roughly where the last 120-week cycle bottomed in December 2000 (which included a 40-week cycle bottom).

Even given the current short-term strength and momentum of the market, we doubt it will manage to retain this strength much beyond May. The beginning of May is where the "hard down" phase of the 40-week cycle begins, which is defined as the final 10% of any cycle length. Prices cannot rise when the dominant cycles are in the final 10% decline, regardless of manipulation.

What made this week's impressive stock market rally possible? Probably 90% of the investing public has a "buy and hold, in it for the long-term" mentality, which means they have held onto their battered shares of Cisco, Yahoo, et al, through the duration of the past two year's decline. As long as the supply of available shares remains somewhat restricted by virtue of the public's large holdings, there is room for large rallies, especially in the early stages of a bear market. Secondary and tertiary reactions in an early bear market are famous for being impressive and often fool traders into believing a "new bull market" has begun. Such was the case in the months following the 1929 stock market crash.

Every bear market is made up of two or more downward legs (primary swings) and at least one secondary reaction. Some bear markets, such as 1909-10, were confined to the minimum. Others, such as the bear market of 1919-21, had 6 primary legs and 5 secondary reactions. The great 1929-32 affair was made up of not fewer than 8 distinct primary legs and 7 secondary, a series not matched before or since.

The great Dow Theorist, Robert Rhea, wrote concerning these bear market swings, "Secondary reactions are as necessary to the stock market as safety valves are to steam boilers." In other words, when the stock market steam engine is straining and too many passengers have climbed aboard, the safety valve (secondary reaction) is released. Although many reasons are given for every move of this kind, it may be said that all secondary serve the following purpose:

  • To correct a primary market movement which has gone too far in one direction, and
  • To dampen the speculative ardor of the amateur trader.

It is invariably easier to call the end of a bear market rally than the beginning. Rhea described one of the best methods for identifying the top: "In such action the peak is frequently attained on a sudden increase in activity lasting a few days. It is usually impossible to pick the turn with any degree of precision; however, if after the high point has been attained a further rally shows a definite diminution in activity, it is probable that an early resumption of the decline will occur."

One explanation for the recent Dow rally is that "mini-bubbles" within much larger market bubbles that are the process of deflating, while often unexpected, do happen occasionally. The analogy of an air mattress is appropriate in the case: when a large air mattress is being deflated, the surface rarely deflates evenly and sometimes bubbles, or air pockets, form in the deflation profess. The financial markets are obviously undergoing a long-term deflationary process from the runaway 50-year bull market that ended in 2000. Since we are still fairly early in this deflation, an "air pocket" (or mini-bubble) cannot be ruled out. That is the best way we have of explaining this unforeseen rally.

Another thing this market has going for it, short-term, is the extraordinarily heavy amount of volume laid down when the market bottomed in late September/early October. This volume was unprecedented in NYSE history and only the market bottom of September/October 1998 is comparable. In fact, we have noted in previous issues the remarkable similarity between the Dow's behavior in late '98 and late '01. Similar observations could be made concerning the market's performance of the first quarter of '99 and this year's first quarter. Does that imply that the Dow will have an overall bullish year much like 1999? No, because in 1999 the dominant trading cycles, including some of the long-term cycles, were still up and topping. In 2002 not only is the 120-week cycle declining but so are many of the yearly cycles, and of course, the K-wave itself is due to bottom around the middle of this decade which means we are in the "hard down" phase of the dominant long-wave economic cycle itself. These conditions did not exist in 1999, so it is highly unlikely we'll have another repeat of that year - only in brief spurts will there be parallels. The point we are making about volume is that it takes a long time to work off volume of this magnitude. Much of that volume laid down in late '01 has already been worked off but some of it still remains. Until it is turned over for the last time there is still upside potential in this market. It is more than likely that the Dow will top this time around on extremely heavy volume, letting us know that the assimilation process is complete.

Does the Dow's breakage of the 10000-10500 critical resistance band and (presumable) rise to 11500 necessarily cancel the previously forecast decline to test 7400 this year? Not at all. In fact, this recent show of strength only increases the odds that the sell-off, when it finally occurs, will be more severe in magnitude and probably even momentum. This latest up-move is obviously a feat of market engineering by the dominant "market makers" and counter-cyclical moves always end very badly. This is because what the market gains through artificial intervention and manipulation must be paid for in increased downside severity when the cycles turn down hard and the market finally breaks. We've seen this happen countless times in the past, on both a small-scale and a large-scale basis.

One respected market technician, Michael Jenkins of Stock Cycles Forecast, agrees with our upside objective of around Dow 11500 and predicts the Dow will tumble to least 6500 before the year ends based on the cycles and trading channels. He has appropriately entitled his latest market missive "Bubble Mania Part 2." A Dow decline to 6500 by later this year would not be surprising since it would mean that the market is simply exacting its proverbial "pound of flesh" in the form of 1,000 or so Dow points for being manipulated against the trend. If this contra-trend move had not occurred, perhaps we would have only visited 7,400. Of course, there is room for a decline even below 6,500 especially if market psychology is at a fevered pitch around the fall of this year when the worst downside activity will be taking place.

Another prominent market analyst has pointed out, much as we have in recent weeks, that real estate and REITs has been a huge beneficiary of most organized market support since Sept. 11. He also surmises that the Fed's liquidity policy of recent months appears aimed more at keeping the mortgage-backed real estate market afloat than anything else. This is a reasonable assessment. The REITs have led the market since then and even more so now. The Morgan Stanley REIT index has skyrocketed nearly basis 40 points in a mere three days since the breakout on Monday. Although the index should begin to encounter resistance above 440 there is still room for further highs this month. We noted long ago that REITs tend to lead the market at tops and in bottoms. The REIT sector was in heavy decline when the broad market was trending up couple of years ago and they have rebounded strongly as the Dow encountered selling pressure in 2000-2001. We would not be surprised if the REITs once again led the Dow by topping a few weeks before the broad market; in fact, many leading REITs appears to already be in the topping process and some may have seen their highs, especially in the home building sector, which has undergone a boom of sorts in the past several months.

Clif Droke is the editor of the three times weekly Momentum Strategies Report newsletter, published since 1997, which covers U.S. equity markets and various stock sectors, natural resources, money supply and bank credit trends, the dollar and the U.S. economy.  The forecasts are made using a unique proprietary blend of analytical methods involving cycles, internal momentum and moving average systems, as well as investor sentiment.  He is also the author of numerous books, including “2014: America’s Date With Destiny.” You can view all of Clif's books here. For more information visit

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