As we come out of a lengthened holiday weekend, I wanted to touch on some market dynamics that appear to be shifting. While 2008 has given buyers little opportunity to make money holding long positions, and volatility has increased the risk levels for long and short traders alike, we are beginning to see signs that a significant low may be in place. This does not mean that I see a clear path to a new bull market starting at this time, but simply that the markets are setting up for an intermediate-term rally that could give investors a good chance to make money holding long positions for several weeks.

They say the news is always the worst at the bottom, and looking back over historical significant lows, one can see how disturbing the news can be. Last weeks near collapse of Bear Stearns marked the exclamation point that is often necessary in a bear market turn. As investors panicked and the fed rushed in to find a way to save the US capital markets, any uncertain holder of stock would have found it very difficult to hold onto long positions. The credit and liquidity crisis we have begun to work our way through has provided the catalyst for many “weak holders” to liquidate their stock positions which in turn drives prices lower. But in the midst of the disruption the question could now be posed: “Who is left to sell stock?” If those who are nervous about the economy have liquidated their positions during a well publicized near market failure, what kind of event would it take to shake loose people who held onto stocks during such a fearful event?

Several months ago, I came across an interesting study which stated that while the market averages typically yield 10-12% annually over the lifetime of an individual investor, most of these investors only capture about 2/3 of this return. The reason was not due to poor funds that these investors put their capital into, but instead resulted from the fear and greed cycle that so many can fall prey to. In this study, an investor was much more likely to liquidate a portion of their account – or even their entire retirement – during difficult market times. In essence, the typical investor would take money out of the market at the worst possible time (near a market bottom) due to the fear of further price deterioration. Conversely, individuals were more likely to add to their accounts or even leverage positions when the economy was running at full tilt (or closer to a market top) which put more assets at risk precisely at the wrong time. The study simply pointed out that a disciplined and steadfast approach yielded much better returns than trading according to the fear or jubilation that comes with bear and bull markets.

With that in mind, as I was driving into the office this morning, the local radio station had a 5 minute segment stating just how difficult the economy has become. The report cited rising unemployment numbers, the drag that higher oil would have on the economy, a falling dollar making the cost of purchases higher for Americans, and a generally dismal picture for consumers over the next 12 months. While there was very little factual evidence that I could argue with, the piece struck me as interesting because this is the news that the average investor is now hearing. And since things look so dismal, the average investor is being pummeled with more and more reasons not to put investment capital at risk.

This is a wonderful scenario for those who would call a market low for now. With so much capital now on the sidelines, and aggressive traders short due to economic weakness, any move forward in the market will likely catch the majority of investors off-guard. As individuals sit on the sidelines and watch a few days of positive market movement, they will likely become discouraged that they exited at the wrong time and bit by bit will put their capital back to work. Short sellers on the other hand, will feel the pain as their assets dwindle in the face of a rising market and they will be forced to cover adding fuel to the relief rally. Investors who are long in front of this phenomenon could make significant gains which will better position them to weather continued economic weakness.

Now this rally could quickly die out if economic metrics do not follow. Historical bear markets have some of the sharpest and most profitable rallies within the context of multi-year downtrends. But for the nimble and open minded, these rallies present a welcome opportunity to capitalize on short-term rebounds within a difficult overall picture. Keep watching this site as we cover which names and sectors are likely to benefit the most from overall trends. 2008 can turn out to be a very profitable year for those who pay attention, approach the market with a disciplined plan, and keep risk controls in place to prevent catastrophic losses.

Good luck trading this week,

ZDS