An Important Test

A quick update . . .

After the recent rally, we're now at what I see as a very important test. We're about to find out if the Fed's huge injections of liquidity have indeed ended this bear market, as many seem to believe.

As far as I can tell, this rally is still pretty much textbook bear market behavior, and the long-term path of least resistance remains down.

Along these lines, the chart below implies that there are swarms of sellers in the 1400 range waiting in the wings to dump their stock into another leg up. Any new rally is going to have to work through this pretty serious supply overhang.

Stranger things have happened, of course. Look at 1998, for example, when the markets broke and then reflated with the help of well-intentioned central banks.

Because of precedents such as 1998, as well as the Fed's popular (though not official) mandate to keep equities from declining even at the cost of the purchasing power of the currency, it's absolutely essential to have circuit breakers in place so that if you're wrong you don't lose all your money if you're short.

I've been thinking about how to decide when this move will stop being "textbook bear market action," and when to admit that City Hall (Bernanke, Paulson, Bush) has won. And I still think that if the S&P seizes a position above 1400 and can prove that it can hold it, I will be forced to reconsider my strategy.

If this were to happen, it would be a frankly surprising show of buying power and one that would have to be respected.

In the interest of full disclosure, though, my humble opinion is that we look very well set up here for a potential retreat in the next week and eventually a retest of the 1275 lows on the S&P.

But the market's gonna go where it's gonna go . . .

Oh, and if you were wondering whether this sort of central bank behavior (panic 3/4 point rate cuts when the markets drop, encouraging new debt to solve a debt crisis, etc.) is good for the world in the long term, the answer is no.

A final note: if we do claw back up into the old trading range, the amount of new credit it's taken to pull us out of this natural market downturn is almost certain to inflate another huge bubble, possibly more than one. There's no telling for sure what it'll be, but those who guess correctly beforehand will make armloads of money.

I'll let you know where I think these bubbles might be if another leg up starts looking like a real possibility.

Otherwise, see ya at 1275!