Short-Term Bounce or Bear Market Rally? (by Closing Basis)

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Since the hot topic of the week is how significant this recent bottom will turn out to be, I decided to go back to our previous two bear markets and see if there were any similarities that we can draw from thereby to make an educated guess.  Now before I get into the charts, I just want to say that just because I see certain similarities doesn’t mean it will happen.  Patterns repeat all the time, but you never know when they will follow through or fail until it actually happens.  That said, let’s get going.

Two things I want to draw your attention to in all three of these charts are MINOR violations of established lows ESPECIALLY when followed by sharp reversals and the level of volume.  In each chart, following a sharp decline, we usually see a consolidation period lasting approximately two months at which time a minor break and recovery occurs (of course, sometimes a major break occurs such as in Nov 2008, but I’m talking about minor breaks followed by quick reversals).  Usually, a positive divergence also forms in the RSI and MACD indicators (which only means the trend is shallower).  At this point, we either see a rally or another leg down.  I have marked all Fed Funds rate adjustments on the charts.  Now, let’s take a look first at the 2007-2009 bear market. 

  2008 minor low violations

In both instances noted here the pattern is:

1. significant new low

2. range bound pattern lasting approximately two months

3. minor low violation with near immediate reversal

There doesn’t seem to be any major difference between the patterns themselves, in fact, I would postulate that the second instance might have become a rally if not for Lehman Brothers collapsing.  However, if there is any “tell” I think it is to be found in the volume.  In the first instance, there was clearly lower volume traded indicating that there were less sellers at that level and more holders.  Also, it happend to be a day that the Fed Funds rate was lowered.  In the second instance, the volume clearly increased before the extreme panic selling.  Just for a little extra, let’s see if this concept holds up in the 2000-2003 bear market.

2000-2003 minor low violations

In the 2000-2003 bear market, there was only one minor violation resulting in a large rally in October 2002 which became the bear market bottom.  In the first two instances, the volume was always either even or greater on the minor violation.  The second instance in this case actually followed a short rally and the consolidation range seems to be the momentum fizzling out.  There is also no dramatic reversal, so this one case I almost think doesn’t fit the pattern established in the other instances.  Now, what are we seeing today?

Present day minor violation

Notice the same 1,2,3 step pattern as above?  The lesser volume low violation along with the positive divergences and the stomach-turning intraday reversal looks to me like we’re in for a significant rally.  Perhaps even breaking 1220.  That is my current bias, but as always price is the key indicator and if it reverses down the right way, I’ll be short again.  Based on this study, I believe the volume “tell” holds for the limited study I’ve done on it and hopefully it adds some perspective for us going forward. 

Today, we’re quickly approaching the downtrend line of the current channel in most indices as well as the usual % distance on these short-term swings.  I’ve already closed my IWM calls today and waiting for a pullback to see how it acts.  If the lows hold I’ll ride the next leg up which should prove to be a fantastic shorting opportunity.  Good luck everyone.  I love it here.