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Worst may be yet to come

Updated: May 3, 2013 12:14PM

Last week the stock market heaved a sigh of relief. The gains were widespread. The broad-based Wilshire 5000 is up 38.66 percent or $3.2 trillion from the market low of March 9.

There's a growing consensus that the worst of the economic news is behind us, and that a rebound in the economy can't be far behind the rebound in the stock market. File all of that under the heading "Everything is Relative."

The unemployment numbers were bad. But not as bad as expected. (Tell that to the 539,000 people who lost jobs in April.)

The banks need to raise "only" $75 billion in capital. (Tell that to the taxpayers who have already come up with billions in TARP money, and to the shareholders whose stake will be further diluted.)

Consumer confidence has rebounded from its all-time low at 37.7 in January, to 39.2 in April. (Tell that to those who confidently purchased homes or stocks back in June 2001, when the index stood at an all time high of 118.9.)

Home prices fell "only" 19.6 percent last month. (Tell that to a homeowner trying to refinance a mortgage that is larger than the value of the house.)

When it comes to the economy, everything is relative. We are relatively a lot worse off than we were a year ago. But some of the statistics are relatively better than they were a few months ago, when so many people feared another depression.

Bull market? Bear market rally?

The stock market has chosen to focus on those relatively better numbers, because the stock market always looks ahead. But is this a new bull market -- or just a temporary rally, an opportunity to sell stocks before another collapse?

A well-known Wall Street money manager said on Friday: "This is a "once-in-a-generation opportunity to get in at prices that haven't been as good since 1982." One stock market sentiment indicator has gone from only 2 percent bulls to more than 80 percent bullish in just the past two months.

The bulls are running. But two legendary traders beg to differ. They each correctly timed this "bounce." But neither feels it will last much longer.

Elliott Wave Theory: lows ahead

Bob Prechter is a stock market technician, meaning he charts historic stock prices and patterns using the "Elliott Wave Theory."

Lest you think this type of analysis is like reading tea leaves, Prechter gained fame predicting the stock market crash of 1987. In 2002 he wrote a book titled Conquer the Crash -- You can Survive and Prosper in a Deflationary Depression. In it he correctly forecast a huge credit contraction, brought on by all the mortgage and debt issues that we're now facing.

Reading this book today, it seems as if Prechter had a crystal ball. That's why his current view of the market is so compelling. After forecasting this current rally in February, Prechter suggests traders should be looking for an exit point soon, an opportunity to sell short. He laments: "On the major trend, there's such a long way down to go."

Pressed to put that into numbers, he said that a normal rally from the 667 low on the S&P 500 would take that index back up to the 1,000-1,100 range. (It's around 900 right now.) After that, he expects the next wave down to be larger than the initial drop of 58 percent. You do the math!

Prechter calls it a "C" wave in Elliott Theory -- and notes: "Declining C waves are usually devastating in their destruction." He says the "credit implosion" is not finished. Much like Japan, he predicts, we'll have to live through a long period of declining asset values, summed up in one word: deflation.

Traders can follow these volatile waves, but where do long-term investors hide during an extended deflation? Not in stocks, or real estate, or commodities -- even though today's prices seem like bargains. "Until the credit implosion is over, the only place to hide is cash -- safe equivalents such as Treasury bills. Holding on to your money will give you a chance to buy the real bargains when the bottom eventually arrives -- several years from now."

I had just finished digesting this forecast from Prechter when I received the latest issue of Bert Dohmen's Wellington Letter. ( Regular readers know that I value Bert's perspective highly, as he uses both technical analysis and an insightful view of both politics and the economy.

Noting that bear market retracements can be deceiving, Dohmen pointed out that the first rally after the historic 1929 crash extended into 1930 -- and produced a 52 percent gain. And then the market plunged another 64 percent!

As for the current rally, Dohmen says time is running out. He advises: "Bear market rallies are usually eye-catching and make the casual investor believe that it's a new bull market. Don't make that mistake and fall into that trap."

Sorry to spoil your day with these unpleasant forecasts. We'll only know in hindsight if the bulls or the bears are right. But it's always dangerous to get caught up in the euphoria of the bullish crowd. We learned that lesson already, didn't we? And that's the Savage Truth.

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