Bear Market Breakdown

The Fed spoke. The market rallied. The Fed stopped speaking. The market slumped. Clearly, what the market needs most is more Fed-speak.

At 2:15 Eastern Time, the Federal Open Market Committee (FOMC) announced that it would do more stuff, if necessary, and less stuff, if not. Initially, investors celebrated the FOMC’s resolve to cure the economy’s malaise, while ignoring the FOMC’s dire assessment of current economic conditions.

Said the Fed:

The pace of recovery in output and employment has slowed in recent months. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls. Housing starts are at a depressed level. Bank lending has continued to contract, but at a reduced rate in recent months.

Maybe there’s a silver lining in there somewhere, but a cloud is still a cloud. This realization seemed to dawn on investors shortly after the Fed’s press release. Initially, the Dow Jones Industrial Average jumped nearly 100 points to a new 4-month high of 10,833. But the rally quickly fizzled, as the Dow ended the trading day with a slim 7-point gain.

Yesterday’s failed rally attempt conveniently coincided with the bearish prognostications of Jay Shartsis, a seasoned and insightful options trader with R.F. Lafferty in New York.

“I’m getting ready for short sales on Wednesday or Thursday of this week,” Shartsis declared two days ago. ”I’m looking at stocks that have been exhibiting highly priced puts (potentially bearish) and that have not been rallying along with the overall market. Three intriguing examples are Valassis Communications (NYSE:VCI $33.36), Rubicon Technology (NASDAQ:RBCN $23.9) and RINO International (NASDAQ:RINO $13.14).”

Shartsis’ bearish call does not necessarily merit our attention, but it probably doesn’t deserve our inattention. Yesterday’s “breakdown” of RBCN – down 9% to a 5-month low – occurred almost exactly as Shartsis had warned…almost. The stock tanked Tuesday, instead of “Wednesday or Thursday.”

Moving from specific stocks to the overall market, Shartsis has been expecting a short-term top to arrive in the middle of this week. “Further evidence for a coming market drop are presenting themselves now,” Shartsis observed recently. “The Daily Sentiment Index has reached 83% bulls, which is the highest reading since last April 26, the day of the market’s last short-term top.”

Additionally, Shartsis noted a variety of short-term trading and sentiment indicators that reflect “a high degree of speculation… I am expecting a short-term market top very soon.”

Robert Prechter, editor of The Elliot Wave Theorist, is matching Shartsis’ bet and raising him 300! “We’re on the verge of the biggest bear market in nearly 300 years,” Prechter predicts. “Because the mania [the bull markets of 1982 to 1999 and 2003 to 2007] was so terrific, it will be followed by a negative trend in social mood that will lead to a complete retracement [to less than 1,000 on the Dow].”

“In a deflationary environment, the last thing you want is to own any financial asset,” Prechter added. “If you stay out of stocks, real estate, gold and other commodities, which will all come down together, then you can preserve your purchasing power [in cash] for the next great buying opportunity.”

Bear markets of this magnitude are “very rare,” Prechter admitted. “I’m taking a big risk [making such a forecast].”

Your editors would not argue with Prechter, but neither would they begin preparing for Armageddon. Even if the US stock market is vulnerable to a major decline, the world is not without investment opportunity. Clearly, many, many US stocks will perform well, even if most of the market simply muddles along.

Eric Fry
for The Daily Reckoning