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Bear-Market Rally, Not Final Bottom


But the risk/reward ratio currently very favorable.


Yesterday around 2 p.m., the bulls started what's now known as the second-largest point gain (91.6 points, or 10.8%) on the S&P 500 (SPX) since its formation in January of 1962.

A pair on the flop, trips on the turn and quads at the river: What more could you ask for when evaluating the risk/reward of a potential move?

Yesterday's action included all the ingredients (technical and contrarian) necessary for this Halloween witch's brew, which will begin the equity markets' next stage. It's precisely what I've been saying would occur - not that I blatantly called an "all-in" when this began yesterday, but, given the circumstances, my firm pushed enough into the pot to make it well worth the potential benefit.

Since the October 10th low -- the "panic" Friday before the 9% Monday gain -- the SPX has been technically forming a descending triangle (a bottoming pattern). The challenge with this pattern is that, if the bottom is broken, it becomes a "continuation" pattern - which can be indicative of a halfway point. Could you just imagine - halfway?

Needless to say, the SPX pushed topside of this declining wedge formation with better-than-average volume. This was the cherry on the cake! So let's step back and take a quick look at what makes the current success probability so high.

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I'll start with the opposing argument: The overwhelming negative sentiment rampant throughout the equity markets.

1. Consumer Confidence Index at a record low - 38

2. Public short-sales at the highest level in over 5 years (a. Sorry, but the public is traditionally wrong)

3. Put/call ratio hitting 1.95 (widespread put-buying)

4. Mutual-fund redemptions approaching all-time highs

a. Lagging number - probably much worse for October

5. P/E ratio for Dow Jones Industrial Average: Zero. Really.

6. Dividend Yield of the Dow is at the highest level in 5 years - 3.75%

7. Bulls vs. bears -- largest spread in years -- 22% to 55%

Now, let's talk technical.

The upward completion of the aforementioned technical pattern, a descending triangle, was wonderful news for the bulls - but it's the underlying momentum and other secondary indicators which make this bottom more probable to hold, in the short-term.

Click to enlarge

As seen in the graph above, we currently have quads:

1. Volume divergence
As the latter half of the descending triangle was being formed, the volume dried up -especially on Friday of last week, as well as this past Monday, where the closing prices were the lowest of the year. (Price divergence)

2. Stochastic divergence (my personal favorite)
Yesterday confirmed a stochastic cross with higher lows while, at the same time, breaking a downward trend.

3. MACD divergence
Again, confirming a divergence and a positive cross-back above zero on the histogram.

4. RSI divergence
The relative strength index (not to be confused with a benchmark RSI comparison) also broke a downtrend and completed a divergence.

The risk/reward entry, to my mind, is very favorable, with the understanding that this will only be a bear-market rally, rather than the final bottom. It's way too early to project, with relative certainty, that stance.

I'm looking for this bounce to travel, at minimum, to the SPX 50-DMA. If, for some reason --such as the Federal Reserve Announcement, for example -- this rally were to fail and break the recent bottom, well - look out below.

Hence, keep your stops tight and your sell tickets close.

Stay tuned, and good luck!

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No positions in stocks mentioned.

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