The great Dow theorists of the past divided both bull and bear markets into three phases. According to Dow theory, the primary bear market was signaled on September 23, 1999. This signal occurred in the third phase of the bull market and will remain valid until it is either corrected or the bear market has run its course. In spite of the mainstream belief that we have entered a new bull market, it is my belief that the rally off of the October 2002 lows has been nothing more than a bear market rally. Given this belief, I want to examine the three bear market phases along with a few other factors that I feel are supportive of this view.
E. George Schaefer described the three phases of the bear market as follows: “The First Phase represents abandonment of exaggerated hopes upon which stock prices were based when they reached their bull market peaks. The Second Phase reflects poor business and earnings reports as they steadily become worse. The Third Phase plunges the market to its final depths as economic deprivation forces many investors to sell against their wishes, regardless of price, in order to raise cash.
Robert Rhea described the three phases of the bear market in a very similar way. More importantly, Rhea goes on and states: Each of theses phases seems to be divided by a secondary reaction which is often erroneously assumed to be the beginning of a bull market. Such secondary movements seldom prove perplexing to those who understand the Dow theory. ....
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The Wall of Worry
It seems that most everyone on CNBC has now officially declared the new bull market. I have heard the comments about the new “post war economic boom” and Dow projections of 12,000. When has a new bull market ever began with P.E. ratios well over 30? NEVER! Furthermore, think about the facts surrounding the sentiment numbers. On June 11, 2003 Investors Intelligence reported 58.7% bulls and only 16.3% bears. This is a ratio of 3.60:1. We have to go back 16 years, to April 2, 1987 in order to see the ratio at these extremes. On April 2, 1987 the Dow Jones Industrial Average closed at 2,320.45. Over the next 13 years the bull market advanced 9,402.55 points and never saw this kind of bullishness.
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Now, I know that many people are questioning if things could be different this time. I have read enough Dow theory and market history to understand that people always think, “this time is different.” This time is not different. We are dealing with human behavior and from all my reading of market history going back over 100 years, humans respond in very similar fashion to similar events time after time. Technical analysis really is nothing more than the study of patterns in human behavior and for this reason I believe that market history and patience is our best guide.
Further evidence that the public has not abandoned their exaggerated hopes can be seen in the COT data. While the commercial’s have continued to build short positions since June, the small investor has continued to take on new long positions. By all appearances the small investor is aggressively taking the bait hook, line and sinker just like a hungry fish.
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