Investors Just Witnessed The Perfect Bear Trap

The stock market is said to be a vicious beast, trying to hurt as many investors as possible. And last week it hurt the bears by luring them into the perfect bear trap.

On July 7, everything seemed to be clear. Most European and some U.S. indexes had just broken below what looked like head and shoulder formations. This seemed to be the logical conclusion of the stock market’s advance off of the March lows, which was a very doubtful move with low volume and horrible fundamentals.

By now, though, we know that this breakdown was not the start of a new bear move … but clearly a bear trap. Instead of the expected follow through to the downside, the stock market turned on a dime. And in a short five days the S&P 500 gained a notable 8 percent!

In just five days, the S&P shot up 8 percent, sending the bears into hibernation.

Bear Traps Are Warning Signs Nevertheless

In having risen above the breakdown line, the sell signal was aborted. Technicians disagree about the meaning of this aborted signal. Some say it was a sign of special strength that prices did not fulfill the technical forecast of this formation.

But others, including Edwards and Magee, the authors of the first comprehensive book on technical analysis, come to a totally different conclusion …

They argue that the market signaled weakness by showing a topping formation in the first place. And the reality of this weakness should be treated with respect - as a harbinger of more weakness to come relatively soon.

I tend to stick with Edwards’ and Magee’s explanation. Especially because …

Stocks Are Richly Valued and Macroeconomic Fundamentals Are Dicey!

If you want to know how dicey the economic picture really is, you don’t have to go any further than the minutes from the Fed’s FOMC meeting on June 23-24. Here’s what you’ll read there:

Nonetheless, most participants saw the economy as still quite weak and vulnerable to further adverse shocks.

(B)anks could face substantial losses in their loan portfolios in coming quarters.

(O)btaining financing for commercial real estate projects remained extremely difficult amid worsening fundamentals in the sector.

Most participants judged that consumer spending would continue to be subdued for some time.

The Fed has admitted that the bleak housing situation could get even worse.

Most participants viewed the (housing) sector as still vulnerable to further weakness.

(L)abor market conditions were of particular concerns to meeting participants. ( … ) Labor market conditions were even more difficult than indicated by the unemployment rate.

This sounds like there are a lot of major, unsolved problems out there.

I fully agree with the Fed’s dire insights. And I want to add that the Fed is famous for being overly optimistic about the economy. They tend to be cheerleaders, always trying to upgrade the psychology of the economy. So if they’re saying that the situation is lousy, it’s probably even worse!

What’s Next for Stocks, Then?

The stock market is back to where it was in October of last year, after the crash. In the bigger picture, however, it has traded sideways since then - including a huge decline to the March lows. And this trading range has become quite narrow since May.

The way I see it then, nothing special has really happened. But somehow this kind of “nothing” has obviously been very nerve-wracking for bulls and bears alike.

If the market was indeed the vicious beast that I described in the beginning of this column, having hurt the bears so much, it now seems likely to go after the bulls …

The trap is set. A lack of follow through, a turn on a dime and a decline in line with fundamentals is all that remains.

The best way to accomplish that is for the S&P 500 index to rise above the June high of 956 and set up an even bigger bull trap!

In doing so, the charts would show an accomplished bottom formation signaling the rally to endure. Bulls would feel vindicated and start buying. And many of the remaining bears would be forced to retreat and abandon their short positions.

Thus the trap is set. The only thing remaining now is a lack of follow through, a turn on a dime and a decline in line with fundamentals.

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