Don't Let Rallies Lure You Into Danger

The market has been very volatile lately in the usual sense of the term, but if you just look at closes rather than intraday numbers, it has not been volatile at all.

The Nasdaq Composite has actually been down in five out of the past nine weeks and has closed down on almost 60% of the days this year. The 30,000-foot view of the market therefore is not actually volatile but just plain negative.

The early part of this week lifted bulls, to be sure, but if you step back a bit, the market remains in a very bearish phase. For more perspective on this point of view, today I would like to provide you with the comments of two top independent institutional analysts whose work I have admired for a long time, and who, right now, are materially bearish.

The first is Dennis Gartman, who writes with colorful omniscience about everything from the economics of Minnesota grain elevators to the oil politics of Nigeria. He was about as blunt as the business end of a baseball bat in his market discussions when we talked earlier this week. The second is Paul Desmond, who will be familiar to many of my long-time subscribers as the head honcho at Lowry's Reports in Florida, which is the oldest technical analysis research fund in the country. Both are materially bearish.

"No matter what you might hear elsewhere, we're in a recession, and recessions create lower stock prices," he says from his office in Virginia. "That's about as complex as you need to make it. We're in a global bear market -- and that means strength is to be sold and weakness is not to be bought."

The former commodity pits trader said that he recognizes that investors cannot just keep their hands in their pockets in bear markets though, because fast-moving rallies (such as the one we saw earlier this week) that appear out of the blue seem to have so much money-making potential.

Gartman observes that particularly in the early stages of a downtrending market, private investors want to buy beaten-down stocks that look cheap. They are still more habitually angled toward greed than fear until they've had all their optimism crushed.

The public is right 80% of the time about stocks, and pros are wrong 80% of the time, but pros make money and most retail investors don't, and here's why. The public does something like this: Make $100, make $100, make $200, make $100, make $50, make $100, lose $10,000. They take small profits and then stick with a colossal loser. The pros do the opposite: They lose $100, lose $100, lose $200, lose $50, make $10,000 -- and then add to the trade until they've made $100,000 because the market is telling them it's the right trade. The public never adds to their winners, and that is why they always lose in the long run. If it weren't so sad, it would be funny.

Gartman suggests that the private investors who wish to participate on the long side do themselves a favor by just hanging tight for now and not give in to the temptations to jump back into the market early or to get drawn into the point of view that there are safe havens such as agriculture and gold. "Cash is a beautiful thing," he says.

So how will we know when the bear market is nearly over and it is time to wade back into stocks? "People will be throwing up on themselves with anger and frustration -- that's when you'll know," Gartman says. "CNBC announcers will be crying. Hope will be exhausted. Then we'll look for a real bottom."

On that cheery note, let's turn to Desmond, who has a more scientific approach. His work on buying and selling pressure -- described in great detail in the first chapter of my new book -- started calling for a heavily defensive investment strategy in late July last year. It was a bit premature, considering that the final market peak didn't come until a selective "fake-out" rally in big-cap stocks ended in mid-October, but no harm done. The early warning gave his clients plenty of time to build cash reserves, while demand was still hot, and to shift portfolios out of high-risk positions.