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December 31, 2008

Stock Market Forecast and Strategy for 2009
by Michael Swanson

This is the time of year where everyone gives out stock market forecasts and this year in particular they are all over the map. David Bianco of UBS AG is calling for a 53% rally for the S&P 500 in 2009. He claims that the first "signs of a dawn of confidence" will cause a total surge in stock prices thanks to cheap valuations and Fed intervention. On the other hand regular CNBC talking head Vince Farrell thinks that "the stock market will take its time forming a bottom - at best. Damage like we have seen takes months to repair."

I'm not going to go out on a limb here and make a guess of how high or how low the stock market is going to go. I just don't see that as a productive game and really know one can know that. I have a plan on how I plan to navigate the market this coming year and an assumption on exactly what the market is going to do is not a factor in my plan.

The most important thing you need to do to make money in the stock market is simple - align yourself with the primary trend of the market. That means recognizing what the current trend of the market is, knowing when it changes, and then making the proper adjustments when it does change.

It sounds easy, but if 2008 taught us anything it is that very few people do this. Not only did the public get crushed in a bear market they didn't foresee, but so did thousands of mutual fund and hedge fund managers. Most brokers and investment advisor sat like a deer in headlights as the market went lower too. The professionals turned out to be no better than the amateurs, and in some cases they turned out to be total crooks. The person who recognized the reality of the bear market for what it was and then took the appropriate investment stance was the rare bird.

In fact most people actually tried to fight reality and come up with wild rationalizations to justify doing so. In the beginning of the year just about everyone thought Bernanke was going to save us, or simply couldn't believe anymore banks could go broke after Bear Stearns did. Those thinking that ignored the crime of Level III assets which meant that most banks were bankrupt. I know Level III isn't a crime but it should have been. Thank you SEC and the lobbyists who bought the politicians sitting on the banking committee. In the summer as the market rallied a popular theory held that the market would blast off once oil prices dropped. And then in the Fall many held on to the belief that Hank Paulson's bailout would save the market. After it passed the market crashed anyway. Now most people expect a big rally, because the market has simply fallen so much.

In all of this talk we have seen in this past year what most of it consisted of was ignoring the big negative trend staring all of us in the face. The market was in a bear market and most people just sat on their hands as it ate their money away. They were too scared to sale, because they feared that if they sold the market would go up without them and make their neighbors rich.

If they would have focused on the big trends of the charts they would not have made this mistake. In 2008 the stock market consistently made lower lows and lower highs as every single rally peaked at a lower level than the previous one and then led to a nasty correction. All of this of course happened with the major market averages below their long-term 150 and 200-day moving averages in a classic stage four bear market decline.

If 2008 was the year of the bear market then 2007 marked a transition period out of the cyclical bull market that began in 2003 and into last year's bear market. Most sectors and stocks went into a bear market way before the broad market averages did in 2007. As you can see from the above chart the NYSE advance/decline line peaked out over six months ahead of the DOW and S&P 500 top in October 2007. The individual sectors themselves were actually even worse.

Between October 2007 and December 2007 I wrote articles warning people that a full blown bear market was upon us and that they had to do whatever they needed to do to adjust to that reality.

In December 2007 I said in an article, "the Worden Brothers TC2007 software breaks the market up into 239 sectors. Since January 1st until today, 110 out of 239 sectors are underperforming the market. Eighty-seven sectors are in the red, despite the S&P 500 still having a gain for the year. Most of these sectors are so far below their 150-day moving averages that those moving averages are already sloping down. In other words 36% of the stock market is already in a bear market." The transition from bull to bear had been completed.

My point in this isn't to show how I was right in December of 2007, but to show that we are in a similar moment right now. It was clear a year ago that we were in a new bear market and to make money in 2008 would require a new set of tactics. Now it isn't clear that we are in a bull market now - hardly - but 2009 is going to be different than 2008 and will require new ideas and strategies that we didn't use in 2008 to make money.

I see 2009 to be similar to what we saw in 2007 in the sense that it will be a period of transition. This time though we will see a stage one transition phase between a bear and bull market. In 2007 most stocks peaked out ahead of the market and went into bear markets before the market averages did.

Right now it is obvious to everyone that we have had a brutal bear market. What happens after a bear market though isn't so obvious to those that obsess over mutual fund holdings, CNBC, or myopically focus on the market averages - which has actually been an important thing to do this year.

A stage one transition phase can last anywhere from 3 to 12 months once it gets started. During the transition phase though most sectors firm up ahead of the broad market averages and a few actually enter bull markets of their own. This causes the NYSE advance/decline line to create a positive divergence from the broad market averages as the consolidation period nears its end.

For instance after the 2002 bear market bottom the three major market averages entered a nine month stage one consolidation phase that paved the way for a new bull market. However, the NYSE advance/decline broke away from the averages to create a positive divergence about halfway through the phase. When you broke down the sectors many sectors had actually began their consolidation phases ahead of the averages and began bull markets of their own ahead of the market too.

Just like when the sector action and advance/decline line warned that we were witnessing a transition period between bull and bear in 2007 the action said a bull market was ahead in 2002 and early 2003.

I expect the same thing to happen again. For the past year I have really focused on the market averages, my best trades being taking short positions against them a few times in 2008. It will still be important to pay attention to them over the next few months, but the important thing to watch in 2009 will be the sector rotation and advance/decline line.

I see 2009 to shake up to be a year of transition much like the nine month consolidation period in 2002. As this transition period ends there will be a few sectors that enter bull markets of their own ahead of the broad market. This is where the money will be made in 2009 - not by trying to guess the bottom of the S&P 500 and just throwing money at it - but by carefully looking at the individual sectors of the market and buying into them as they enter bull markets of their own.

And when it comes to bull markets I prefer to buy individual stocks rather than just ETF's. The big money is being made by buying the best stocks that are in the best sectors just as they begin new bull markets.

This is what we have to look forward to in 2009. However, right now it is not clear yet that we have actually seen the final bear market low. For one thing when I look at the sectors only a few have clearly gone through a quarter of their stage one consolidation phase. Most sectors made new lows in November and have simply rallied the past few weeks on low volume. They could simply have had another bear market rally. If they did bottom they have not based above that bottom enough in regards to time to be able to say with certainty that they are going through a stage one consolidation phase.

There is only one sector that looks like it has the potential to go into a new bull market in the coming quarter and that is the airline sector. It is the ONLY sector that appears to be approaching the end of a stage one consolidation phase. I see only a few other sectors that appear to be halfway through their consolidation period - mainly regional banks and some construction related stocks - but as a whole it is not clear that most sectors have even begun their consolidation periods.

Over half the sectors will be near the end of consolidation phases as we approach the beginning of the next bull market. There is only one in this position now. That means we are not about to start a new bull market - not yet.

In other words the broad market has not even begun its stage one consolidation phase yet. That means that we must assume from a risk/reward stand point that the bear market is not over. Buying based on the assumption that it is the bottom, because it must be is not a good idea. Many people thought the bear market ended in March and July because it fell a lot then too and they were wrong. Lower prices is not enough to just assume the bear is over.

At best the market is just beginning a stage one consolidation phase. At worse this is just another bear market rally like we saw in May and August that will lead to lower prices.

There is no way to know for such which is the case. What we do know for sure is that this rally is not the start of a new bull market and that we are going to go through a period of transition before the next bull market begins - and we haven't even gone through that process yet. That means it is coming, and will almost certainly start in 2009.

I am trying to boil down to you what we KNOW for sure about the market. Instead of giving you predictions and guesses on the market and speculations on what the economy is likely to do or what I think it should do I want you to KNOW what the trend of the market is and what you can expect. I want to stick with facts and make conclusions based on pure logic in this article. This is the key to making money - aligning yourself with the dominant market trend and then adjusting to changes in that trend when they occur.

In 2008 that meant shorting rallies. Once the market goes into a transition phase new strategies will be needed. Towards the end of the transition phase you will want to buy the strongest stocks in the strongest sectors poised to go into new bull markets. Buy the right stocks at the right time and you will double your money.

That's what you do towards the end of a consolidation phase. You buy and you buy big.

We aren't at that point yet.

Until we get to that point the market averages will have a down and then sideways bias. Once this rally ends the next move may be to new lows. Even if the consolidation period is beginning you can still get new lows. That is what happened in 2002. And in 2007 when the bull market was nearing an end even though most sectors were entering bear markets of their own ahead of the averages the averages had one last hurrah in October 2007. Everyone who didn't watch the sectors and just watched the averages got their head handed to them as a result.

Now during transition phases the markets trade in a trading range, in which the market tends to top out at a defined resistance point and then trade down to form a new support level. If the market bottomed in November that topping point would most likely be in the 1,000 - 1,050 area of the S&P 500. For me the easiest way to make money in bear markets and in the first 1/2 of a stage one consolidation phase is to short the rallies when they come to an end.

Going forward for 2009 then the best way I see to make money will be to short the market averages once/if the S&P 500 rallies above the 1,000 level. If this rally continues into the first week of January I'd expect it to come to an end by mid-February at the latest. If we get in on the short side then cover and take profits on a move back down near the November low.

Then sit back and see how the sectors evolve. If they still don't perk up short the next rally. If more of them get into bullish configurations then do the research on individual stocks and companies with a plan to buy in big. If the bear market is over then on a retest we'll start to see some sectors stop falling with the market averages and a positive divergence begin to firm in the NYSE advance/decline line. That will be a sign that we need to shift our attention to buying individual stocks in the best sectors to prepare for a new bull market.

What I am describing to you is a major shift in strategy - not to happen right at this exact moment, but at some point next year as it becomes clear we are in a transition phase. This is the best strategy I know to not only make a lot of money, but do so safely by buying at the right time, because it adjusts to a transition phase.

Of course this philosophy means you will not buy on the exact bottom of the bear market. But I don't care about that. I want to buy into the best stocks in the best sectors and then watch them immediately enter bull markets and make me a lot of money. Who cares about trying to guess the exact bottom when I can double my money without much worry at all. I don't like to buy and pray. That's a game for mutual fund managers who obsess over index benchmarking and are more interested in making sure they stay in pace with benchmarks than they do in making a lot of money and the general public who don't know what they are doing.

Neither of these groups of investors though adjust at all to changing market conditions. That's why they just sat there and got wiped out in 2008 and really won't fully take advantage of the opportunities that will come in 2009.

Yes the bear market may have another leg to it once this rally ends. I know the economy is bad and is likely to get worse. Next year may turn out to be the worst year of our lives when it comes to the economy. But even if that is the case I still expect the stock market to begin this transition and that will mean some of the best opportunities to make money in the market are ahead of us in 2009. It will be an exciting year for us when it comes to the stock market. When a market has one of the worst bear markets ever there are great opportunities that line up.

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Michael Swanson,
WallStreetWindow.com

Disclaimer: Michael Swanson is the President of USA Capital, Inc., which provides management, support, and research for institutional investors, hedge funds, and mutual funds. The ChartWizard is also an employee of USA, Capital, Inc. Both Swanson and employees and associates of USA Capital, Inc. may have a position in securities which they mention on WallStreetWindow or any of its services. In such cases, appropriate disclosure is made. Under no circumstances should the information received from WallStreetWindow represent a recommendation to buy, sell, or hold any security. WallStreetWindow contains the opinions of Swanson and the ChartWizard and is provided for informational purposes only. Neither Swanson, the ChartWizard, nor TimingWallstreet, Inc., which owns WallStreetWindow, provide individual investment advice and will not advise you personally concerning the nature, potential, value, or of any particular stock or investment strategy. To the extent that any of the information contained on WallSteetWindow may be deemed investment advice, such information is impersonal and not tailored to the investment needs of any specific person. Past results of WallStreetWindow, the ChartWizard, or Michael Swanson are not necessarily indicative of future performance.

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