TAKING A BIG STEP BACK -- BREAKING DOWN THE BIG TREND -- BULL MARKET STRATEGIES VERSUS BEAR MARKET STRATEGIES

A LOOK AT THE BIGGER PICTURE... Today's Market Message was written by Arthur Hill. John Murphy will return next week. - Editor

The S&P 500 has experienced two big trends over the last eight years. Let's look at these big trends to understand more about bull markets and bear markets. A bull market is simply an extended uptrend, while a bear market is an extended downtrend. Chart 1 shows the last bear market from March 2000 to October 2002. The S&P 500 declined from 1527 to 800 (727 points) over 31 months or 47.6% in about 2 and a half years. Chart 2 shows the last bull market from October 2002 to October 2007. The S&P 500 advanced from 800 to 1561 (761 points) or 95% in a five-year period. Notice that the points lost and gained were about the same for each period. However, it took a 95% gain to make up for a 47% loss. Keep this in mind: it took twice the percentage gain to make up the loss.

Chart 1

Chart 2

TREND BASICS... Breaking it down into basics, an uptrend is a series of higher highs and higher lows. Conversely, a downtrend is a series of lower highs and lower lows. Prices do not move in a straight line, but rather zigzag in the direction of the trend. There are counter-trend advances within a downtrend and counter-trend declines (corrections) within an uptrend. With the breakdown over the last few months, advances are now considered counter-trend. As such, they run against the larger downtrend and are expected to fail below the prior reaction high. The subsequent decline will forge a lower low. Chart 3 shows the S&P 500 with its breakdown over the last few weeks. The last reaction high formed at 1523.57 and I would expect a counter-trend rally to fail below this level. In fact, as noted in Tuesday's commentary, I would expect resistance around broken support (~1400). I would also expect RSI to meet resistance in the 50-60 zone.

Chart 3

BULL MARKET RSI... What works in a bull market is a lot less likely to work in a bear market. With downtrends underway in the major stock indices, it is time to move from a bull market mentality to a bear market mentality. This means looking at indicators in a different light. Throughout 2007, I showed chart examples using RSI to identify pullbacks in an uptrend. Chart 4 shows the S&P 500 in a bull run with 14-week RSI. Notice that the 40-50 zone acts as support in an uptrend. RSI dipped below 50 numerous times, but held above 40 from late 2004 until late 2007. These dips into the 40-50 zone served as an alert to start looking for the end of the correction.

Chart 4

BEAR MARKET RSI... Now let's turn this RSI technique around for a bear market. Instead of the 40-50 zone acting as support, the 50-60 zone now acts as resistance. Chart 5 shows the S&P 500 in a bear run with 14-week RSI. The downtrend in SPX got underway with the sharp decline in the second half of 2000. RSI became oversold and bounced back above 50 in May 2001 (blue arrow). This marked resistance and indicated that the counter-trend advance was coming to an end. The same thing happened in December 2001 and March 2002 (red arrows). With the S&P 500 entering a new bear market phase recently, we need to keep our bear hats on when looking at indicators. Positive divergences and oversold readings are not going to work well in a bear market or extended downtrend. This is also a good time to go back and look at prior bear markets to see how various indicators worked-or didn't work.

Chart 5