Stocks Bear Market is Smashing Everything- Shorting the Rallies

By: Michael_Swanson

On Thursday the DOW fell over 300 points. I made a killing on my short positions, but gold stocks fell hard too. Luckily I got stopped out for a small loss the day before, but nonetheless I don't like seeing gold and commodities drop at all here. The bear is acting worse than even I had expected and is now smashing everything in sight.

You see Thursday was a game changer for me in some ways - a true eye opener. I'm not surprised the market dropped. I went short last week so I was looking for a decline of some sorts. I'm a little surprised by how much the market dropped Thursday though. I've gotten lots of emails from people who missed the short trade and want to know if they should get in now.

No!

You need to short rallies. If you short after the DOW is down 300 points in a day you can expect to have the market come back on you and give you a loss. You need to wait for a 1-3 day rally before you short. I'll explain how at the end of this message.

Don't think about shorting now. I want you to step back and think about what is going on in commodities.

First I have talk about why I thought yesterday is a game changer for me. I'm comparing it to August of last year. If you remember the market had a fast and furious correction and took gold stocks down with it. The Fed stepped in and intervened to stabilize the market. A few weeks later they cut rates by 75 points and the market rallied and then rolled over to begin the bear market.

But those few days in August 2007 opened my eyes. They date the start of the credit crisis and frankly that correction scared me. It made me look very closely at the market and take a careful stock of things so we could see what was coming. We recognized that a bear market was upon us.

But the point is that August made me realize that things were changing in the market and it was no longer time to be complacent, but to adjust tactics and start to think about shorting - something I hadn't done in five years before last October.

I've had a good year overall return personally over the past twelve months. I shorted some in October and November. Tried to buy gold stocks in December and got stopped out. Then stayed in cash until the market got near its January low. I bought that low then got stopped out. Watched the market rally from March to May then shorted in May and covered the morning the market put in a bottom in July. I sat back and went long gold when the HUI got down to 400. Got stopped out and bought again on the day gold stocks bottomed in August on almost the exact bottom. I then went short the S&P 500 last week and got stopped out of my gold stock position when it fell about a quarter of a percent from where I got in it at the other day. But my shorts look good.

By recounting my moves I want to bring one thing to your attention - I've made several key strategic trades this year and have timed bottoms fairly well. But those bottoms all proved to be temporary and I only got rewarded by getting stopped out for small losses for my efforts. All of the money I've made in the past year has come from shorting the broad US stock market at some key junctures. All of that money has been made in a combined 8 week period - the whole rest of the time I've basically been spinning my wheels trying to play bottoms in different sectors of the market.

I'm not complaining. I've made some good money overall - but the point is that this is a market in which trading on the long side has not paid off and shorting rallies has. It is a pure bear market.

Now in the first quarter of this year oil and commodity stocks bucked the bear trend and remained in bull markets. But in July oil stocks made a peak too and corrected hard, taking gold stocks down with them.

In August the correction in gold stocks got so intense that it reached a magnitude only seen a few times in the past 25 years. By all of my indicators a major bottom in gold stocks should have been made in early August - but the recent price action negated that bottom.

That means lower prices for gold stocks and commodities are likely ahead. Don't try to figure out the reason why. It's just what the charts say and in the end I make my decisions based on the charts and not where I think or want things to go.

This is a big deal for me, because I have been involved in the commodity bull market and gold stocks now since 2002. We've seen some big corrections since then, but none like this.

The bull market for oil and commodities seems to be over for now. They will have to at best spend several months repairing the damage they have taken before they can resume their bull market and at worst they may end up declining with the rest of the stock market for the next several quarters.

That is why for me the action last week is as much as a game changer for me as the action in August 2007 was. I have been a big gold bull for years and have looked to buy bottoms in gold in the belief that each bottom would be a big buying opportunity. But for now I'm going to sit back and not even try to buy the next bottom, but wait first for the gold stocks to stabilize and then consolidate and repair their damage before getting in again.

That's just the type of market this is. As I said for the most part this year trading on the long side has not paid off while shorting has.

And the market is getting worse. Oil stocks and commodity stocks were the only major sector that remained in a bull market this year. With them in some sort of bear market there is now no major stock sector in the US market that is still in a bull market. I use TC2007 to study the market sectors. It breaks the market up into 239 sectors. Less than 20% of those sectors are above their 200-day moving averages and less than 10% of them have a positive return for the year.

In other words 90% of the sectors in the market are making people lose money.

People are losing big money in the stock market. Huge money and the decline isn't over yet. In fact the action suggests the bear is entering a more brutal form.

Back in May I was telling people that I was looking for a decline into July - then a bounce into August - and another drop into October. At the same time though I had thought gold and commodities would continue higher and bonds would decline along with the dollar. Instead commodities are falling with the rest of the market and the dollar and bonds are rising.

This has surprised me. But I recognize it for what it is - a pure flight for liquidity.

Last August when the market dropped hard we saw the same thing happen. And it happened again for a few days in January and in March too.

The difference though is that during these three times it happened when pure panic entered the market and the market was at or just about to bottom.

That isn't the case now.

This looks like the start of a new leg down for the market and not the end of a decline. Up until now gold stocks and commodities would actually buck the declines of this bear market until the last few days of a decline - then they would drop. But this time they are falling at the start of a market decline. That's a different pattern from what we have seen in the past and I think it means that this corrective way may end up being more frightening then the two previous ones we've seen so far this year. It appears that hedge funds and institutions are literally running away from everything and diving into bonds and the dollar. No matter that in the long-run those may not be prudent things to invest in, but for now for whatever reason all they care about is cashing out - and their selling is driving every stock sector down.

This is likely to continue until we see this correction come to an end and no end is in sight at the moment - and probably won't be until we see the market go through its July lows - and that has the potential to snowball into a big sell-off.

In a market like this preservation of capital is key. There is nothing wrong with having high cash reserves. Shorting isn't appropriate for everyone, but managing your risk and knowing when you will cut losses is key. You've seen me do once with gold stocks last month and I just did it again last week.

Now lets talk about shorting tactics.

The rest of this article is reserved for WSW Power Investor Members only.

By Michael Swanson
WallStreetWindow.com

Mike Swanson is the founder and chief editor of WallStreetWindow. He began investing and trading in 1997 and achieved a return in excess of 800% from 1997 to 2001. In 2002 he won second place in the 2002 Robbins Trading Contest and ran a hedge fund from 2003 to 2006 that generated a return of over 78% for its investors during that time frame. In 2005 out of 3,621 hedge funds tracked by HedgeFund.Net only 35 other funds had a better return that year. Mike holds a Masters Degree in history from the University of Virginia and has a knowledge of the history and political economy of the United States and the world financial markets. Besides writing about financial matters he is also working on a history of the state of Virginia. To subscribe to his free stock market newsletter click here .

Copyright © 2008 Michael Swanson - All Rights Reserved.

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