Is Your Portfolio Ready For The Next Leg Down?

• By Simon Maierhofer
• On 11:53 am EST, Monday February 2, 2009

SAN DIEGO (ETFguide.com) - 'The bear market is over! The Dow is at a 30% discount! Witness the stock sale of the century!' You've just read December headlines features by Morningstar, TheStreet.com and Stock Trader's Almanac.

We beg to differ. 'Now is the time to sell' is our stand. Before you dismiss this bearish notion, consider this: In October when everyone was hopeful the bailout will fix the system, we described the financial sector as a 'downward spiral with no-stop loss provision'. Our assessment was that the Dow will have to drop below 7,500 before rallying into November/December.

Looking at the track record

The Dow Jones (AMEX: DIA - News) did drop from 10,500 to 7,500 in less than 50 days. The Financial Select Sector SPDRs (NYSEArca: XLF - News) shed 50% since our downward spiral assessment. This was followed by the expected November/December rally (forecasts available to subscribers of the ETF Profit Strategy Newsletter).

Back in October and again in early January we recommended short ETFs such as the ProShares UltraShort S&P 500 (NYSEArca: SDS - News), ProShares UltraShort Nasdaq (NYSEArca: QID - News), ProShares UltraShort Consumer Services (NYSEArca: SCC - News) and ProShares UltraShort Financials (NYSEArca: SKF - News).

Did you hear the bell ring?

Our skepticism has paid off while many fell for the markets bluff and bogus forecasts. Even though Wall Street doesn't ring a bell when the market hits rock bottom, some believe to have heard a bell nonetheless. How can that be?

Just as a farmer has to be familiar with weather patterns, investors have to be familiar with certain indicators. There are short term and long term indicators. Right now I see that short term indicators are used and misinterpreted for long term forecasts.

Short term indicators:

Some indicators like investor's sentiment (Investor's Intelligence Sentiment Survey - II) and the CBOE Volatility Index (VIX), also called the fear indicator, did indeed record extreme readings in November 2008. Such extreme readings are often indicative of market bottoms. The November lows haven't been breached (yet), so the question is whether the indicators market a permanent or a temporary bottom.

Imagine a farmer in the mid-west. Once Fall has passed, he expects snow. He knows that a few sunny days in January don't mark the winter's end, even if the weather channel forecasts more sunny days to come. Larger seasonal forces override any temporary high forecasted by the weather man.

Within a larger-scale frame work, extreme readings in the VIX and II are overshadowed by larger movements. How do you know larger forces are at work and how can you ascertain the direction of larger scale moves?

A house built to last needs to be built on a solid foundation. Any forward looking market guidance needs be based on reliable indicators. Indicators are like pieces of a puzzle; when put in place correctly and viewed as a composite they create the full picture.

It is tempting to believe that the S&P 500 (AMEX: SPY - News) and other broad market indexes like the Vanguard Total Stock Market (NYSEArca: VTI - News) have bottomed after a 40% decline. But this is hopeful thinking, here is why:

Long term indicators:

To see whether short term indicators signaled permanent bottom or merely a short term speed bump, we have to take a look at a composite of long term indicators. Such indicators flash a clear message, similar to street signs. If you follow the signs, you won't get lost.

By now even Joe Plummer knows that excess liquidity created the real estate and equity bubble. Both bubbles are denominated in dollars. The government's inflationary policy has caused valuation to get out of whack. The only way to assess the actual value of the stock market is to measure it in real currency.

Gold! Gold (NYSEArca: GLD - News) is the only true measure of value. In 1999, one share of the Dow Jones was worth 42 ounces of gold. Today, one share of the Dow can be bought for less than 10 ounces of gold. This represents a 76% decline in real money. Eventually, the Dow measure in dollars will catch up to the Dow measured in gold.

A comparison of the current P/E ratio to historic averages provides another big chuck on the puzzle.

Mutual fund cash reserves, in essence an off-shoot of the investor sentiment indicator, also paints a clear picture. Mutual fund cash reserves hit an all-time low of 3.4% just weeks before the stock market reached its all time high in 2007. Cash reserves have increased slightly but will have to reach double digits to indicate a large shift of investor sentiment.

Many consider dividend stocks as 'widow and orphan' stocks. Far from it, dividend yields accurately foreshadow the market's direction. Again, dividend yields reached an all time low of 1.42% at the 1999 peak.

The December issue of the ETF Profit Strategy Newsletter compared current dividend yields with dividend yields in past areas of economic distress. Lesson learned; markets don't bottom until dividends reach a breaking point. This implies a further (significant) drop in the Dow and other indexes.

Is your portfolio ready?

No bear market keeps falling continuously without bear market rallies. Short term indicators, as mentioned above, can help in discerning short term tops and bottoms. In fact we used short term indicators to issue a sell signal on January 6th, 2009 (Dow 9,050). The Dow has dropped 1,000 points since. The investor's sentiment leading up to the January 6 top reached such extreme levels, it rivaled the optimism leading up to the October 2007 peak.

The 'big picture' analysis of the short and long term indicators leads us to believe that the first six months of 2009 will see new lows and the onset of the largest bear market rally since October 2007. Is your portfolio prepared? If not, make the ETF Profit Strategy Newsletter your bear market headquarters.

Buzz up!