The race to the bottom – and what lies beyond

Thursday February 20, was another important day in the markets – especially the US. The main reason is that the Dow Jones Industrials Index closed below its November lows. In technical parlance, this is known as ‘making a new bear market  low’ and, by so doing, the market has ‘confirmed’ that the bear market is still in force. That confirmation was reinforced by the fact that the market fell further on Friday, rather than bouncing back.

This reflects technical analysis principles which demand that every trend has to ‘confirm’ itself every so often, by pushing to new extremes, whether on the upside or downside. If that doesn’t happen, the trend ultimately ceases to be in force and the market may be described as in a ‘sideways trend’, until such time as it makes a big move in the opposite direction to the previously-dominant trend – at which point it is legitimate and correct to define a new major trend as being underway.

The Industrials’ move on Thursday came as no surprise, because the Dow Transportation Index had made a new low for the bear market earlier in the month. Indeed, on Tuesday, Wednesday and Thursday of last week the ‘Trannies’ made SUCCESSIVE DAILY new low for the current bear market – which really tells you everything you need to know about both the market and the economy in the US. Furthermore, the Russell Index had made a new low the week before, so that once again the small caps led the large caps. The fact that neither the S&P 500 nor the Nasdaq Composite have yet hit new lows is not important; on the contrary, it is virtually inevitable that they will do so shortly.

All this has moved Richard Russell, the venerable (86-year-old) guru of Dow Theory to swing back to being bearish. By the tenets of Dow Theory, Russell had no choice but to do so – but although Russell’s frequent zig-zags have made his calls problematic, we don’t need to attach great weight to him personally, since the overwhelming majority of technicians are now very bearish.

The important question is where this is leading, at least in the short term. Robert Prechter, the most prominent guru of Elliott Wave analysis – a complex, but fascinating branch of technical analysis – expects the S&P 500 to not only break its previous low of 741 – his minimal target for the current down-leg – but to sink as low as 600-650. The Industrials, on this basis will reach about 6500 and other indices will record similar declines.

This scenario is not only plausible, but is already taking shape globally. The Nikkei 225 continues its race to the bottom with the Dow Industrials. The Dow’s falls on Thursday and Friday gave it the lead again in this macabre race, despite parallel falls in Japan, and even the additional fall in Tokyo today (Monday, Feb 23) left it a few points above the level that the Dow closed last week.

Meanwhile, in Europe – which is the current epicenter of the global rece/depression – several important equity indices, notably the CAC40 and the DAX, have made new lows for the bear market, in some cases by significant margins over the previous ones.

The markets that have been relative outperformers recently are Emerging Markets, especially in South America. Whilst the CEE markets from Prague to Moscow have been crucified, Brazil and some others are doing quite well. The Asian scene is inconsistent, with China’s market performing strongly in response to the government’s measures there. The relative strength of the Israeli market needs to be seen in this context of global EM trends, which help explain how Tel Aviv has been doing well whilst both macro and corporate fundamental data here are awful and getting rapidly worse.

Of course, equity markets’ internal dynamics do not have to generate an exact fit with fundamental news. Technical issues such as fund flows, seasonality, etc. are important in any but highly abnormal markets (such as those of Sep-Dec 2008). This means that the markets currently doing well may ‘catch up’ with global weakness later; in the case of Israel, this has happened before and is therefore a plausible and even probable scenario. [The Chinese market is protected by capital controls from direct exposure to global trends, and hence tends to go its own way – but it cannot forever ignore domestic fundamentals, which are themselves heavily influenced by global developments.]

Coming back to the developed markets, and the US in particular, the current down-leg confirms that the bear market is alive and well and, for Russell, Prechter and other technicians, actually confirms the much grimmer fact that this is a ‘great bear’ or ‘super-bear’ market. But whilst the implications of this terminology are horrendous, in that they imply ultimately much lower lows than the ones targeted near-term, they do not mean that the markets will fall non-stop.

On the contrary, both experience and the theories derived from it agree that major trends never develop in a continuous path. A bear market is punctuated by counter-trends that can be either short and sharp, of the sort we have already witnessed (in mid-March-mid-May 2008 and in November 2008- January 2009), or quite long and large. In other words, we could see an upward move extending several months and carrying indices up by anywhere between 50-100%.

Such a move would not negate the bear market, but is rather an intrinsic part of it. If, for example, the S&P bottoms at 650 and then rises to 1100 (a move of almost 70%), this would not sound the all-clear or signal recovery – but many people will probably convince themselves that that is precisely what it means. In this scenario, the bear-market rally will draw in many optimists only to then fall again to still lower lows, inflict further losses, pain and damage along the way. THAT is what a ‘super-bear’ does.

The effective strategies, therefore are either to remain entrenched in cash and to avoid risky assets such as equity for a much longer period of time, OR to seek an entry point into risk assets at or near the bottom of the current move. Since no-one knows where that bottom will prove to be, the only valid approach is to pick a target or range and to buy once that has been reached, perhaps on a gradual basis that allows for further purchases if the market falls below the target chosen.

But the critical point is not when to enter, but rather to remember to exit when the rally has become a substantive move, and not be lulled into believing ex-post that the coming bottom is THE bottom of the whole mega/ super/ great bear. Both fundamental and technical analyses strongly suggest that it won’t be THE bottom – and it will be essential to remember that fact even if the upcoming market low remains in place for a year or more.

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