Bear Market Rally Highly Likely; Sell into Strength

After a punishing decline in June, U.S. and international stocks are due for a serious bear market rally. And the number of traders betting against further declines, known as the level of short interest, now sits at a record 3.6% of listed equities in the United States. That means a vicious, powerful counter-trend rally is highly possible in July or August.

The 55 percent jump in short interest since October exceeds all other gains since 2000, according to Bloomberg. The six previous increases averaged 28 percent and lasted 11 months. During those periods, the S&P 500 declined an average of 6 percent.

But before breaking out the champagne to celebrate the end of this bear market, remember that we’re still a long way from the finish line as it pertains to housing and credit. Also, the Fed has lost control of inflation – many foreign central banks in Asia are way behind the inflation curve and other emerging markets will follow amid skyrocketing food and energy prices.

Bear market rallies tend to be awfully convincing.

Previous bear market rallies from 2000 to 2002 resulted in big single-digit gains for global stocks. But gains were savagely cut as investors eventually headed for the exits at the same time as the economy deteriorated until prices finally bottomed in October 2002. But by then, the MSCI World Index had plunged more than 50% from its March 2000 all-time high and the S&P 500 Index more than 40%.

From its all-time high last October, the MSCI World Index now trades about 22% off its best levels and the S&P 500 Index is down 21%. According to Ned Davis Research, the average stock market decline in a bear market suggests we still have another roughly 10% of losses ahead as earnings deteriorate.

Personally, this is the worst year I’ve seen since 1998. And I’ll be candid like always.

Most of my recommendations have been pulled sharply lower over the last 12 months – including my contrarian value investing strategies. Most of the stocks I’ve been buying – already down more than a third or more at the time of their purchase, have declined even further in this mess. Only gold stocks are working for me along with positions in agriculture, the yen and reverse-index funds. Until last week, only oil and gold stocks, fertilizer companies and coal shares had rallied in 2008. If you don’t own these stocks, forget it; the rest of the market has literally tanked.

The final stage of bear market capitulation has not occurred. The pain will truly end when everyone is dumping stocks en masse and more losses are inflicted. Use any intermittent bear market rally this summer to sell stocks. The worst is not behind us.

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