Today’s Trading Lesson From TradingMarkets

Editor’s Note:

Brice

How To
Tell The Difference Between A Bear Market Rally And A Real Bear Market Bottom

This lesson is a little bit tougher to write because of the many
variables involved. I decided to narrow it down to a few very important signals.
Studying past bear markets and their transition
back to a bullish stance is, I believe the key to telling the difference between
fake rallies vs. real ones.

First off, new bull markets typically do not start in a second. Every time the
market has an up day, it seems analysts come out of the woodwork calling for a
bottom. It has taken  time to repair the damage of previous bear markets. This
is called base building. It is not very often the market will make a “V” off 
the lows. During the year 2001, there were a couple of occasions where sudden
rallies did occur. They were in January and the March/April period. During both
those times, the market had no time to repair damage.

It was more or less
snapbacks off of oversold conditions… kind of like we could be seeing right
now three weeks after the terrorist attack.                                   

Technical Characteristics

I have described typical bear market rallies as having certain characteristics.
Simply put, they happen quickly, they are sharp, they feel good but bury you
quickly… after many investors are sucked in. This
is what happened during the periods mentioned earlier. January’s rally lasted
all of three weeks and the March/April rally lasted 10 days before exhausting
itself. Cries of a new bull market were heard across the land but to no avail.
The market would not cooperate. These occurrences have happened in past bear
markets  It is very tough to ignore these rallies. During these times, investors
who have lost money are wanting to make it back any way, shape or form…usually
jumping the gun.

Leadership

Practically by definition, all new
bull markets have to have leadership. This is measured in how many
New Highs there are and what the
New Highs are. Quality
names are key. I  also want to look for certain sectors that almost always have
done well at the start of  new bulls… including Financials and Technology.

Every new bull market that I have examined has started with a follow-through
day, but not every follow-through day has led to a new bull market. There were a
few of them that occurred this past year, to no avail.

Stocks Breaking Out                                               

Sentiment is very important to me during bear markets. Up until August 2001,
even after the major drops, sentiment remained bullish. 

I read sentiment several ways:

Put/call ratios: This measures the amount of panic on a short-term basis.
Normally, investors buy calls because of optimistic views on the market. When
the puts spike, it generally has meant that investors have become panicky. This
ratio measured an all-time high reading not coincidentally on 9/21, the day the
market put in its near-term bottom. Keep in mind, this is a short-term gauge.

Bullish vs Bearish: I measure this by reading the
numbers from Investors Intelligence. They track newsletter writers and their
stance. When they  become too bullish, the markets have usually dropped and vice
versa. Up until August 2001, they remained bullish. They are now finally
bearish.

Stock splits: When markets have topped, there have usually been a ton of
splits because stocks have had a good run. When markets bottom, there are
usually hardly any because most everything is down.

There are other things to look at but for me the most important are price action
and volume. I have seen oversold markets get more oversold and overbought
markets get more overbought. As of this writing, 10/10/01, the markets are in an
uptrend after Follow Through Days on all the major
indices. This has happened before. This latest
rally started on the first attempted rally off the low on 9/21/01. It occurred
as sentiment became as bearish as can possibly be measured by some of the
indicators I mentioned. There still remain many cross-currents.

The
Bearish Case

• The margin debt has
  dropped 12 of the past 17 months.

• World markets are still
  in major downtrends.

• Breakouts, while doing
  a little better, are still failing.

• This rally seems to be
  sharp and quick. It is also starting to feel good. You get the hint.

• Lack of leadership 

• Major indices still
  trading below moving averages.       

 

• Sentiment is still
  bearish.

• The markets are still
  moving up after their follow-throughs.

• The Fed has lowered
  rates nine times in nine months. This is unprecedented.

• All the news is bad.

• No stock splits.

• Hardly any IPOs or
  Secondaries.

Which way does the market
go? Your guess is good as mine. I will just keep watching for clues.