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Bear Market Returns

Three charts saying the bear market rally in stocks is finished...

The ECONOMIC RECOVERY that so many economist and investors pretend to see is struggling to make an appearance in the real world, writes Eric Fry in the Rude Awakening.

This illusion of recovery never seems to produce any actual economic recovery...although it does produce a fairly steady demand for stocks.

The more that folks talk about recovery, the more they buy stocks. And the more they buy stocks, the more the market rises...which causes folks to talk more about a recovery, which causes them to buy more stocks.

As this process gathers momentum, the buyers become increasingly confident and indiscriminate. Eventually, investors will buy almost anything at almost any price...because they know that tomorrow's share price will be higher than today's.

This mindset creates a kind of feeding frenzy, in which the most speculative issues in the stock market attract the most enthusiastic buying interest. Typically, the more conspicuous the signs of reckless speculation, the closer the end of the rally.

On this basis, the end of the current rally may be VERY near.

During the stock market rally of the last six months, the shares of financially weak companies have trounced the shares of financially strong companies. This phenomenon has become particularly pronounced during the last few weeks.

The chart above tracks the performance of the financially weakest stocks relative to the strongest ones. The weak stocks are winning.

"The companies [in the chart] were identified using New York University Professor Edward Altman's Z-Score method," Bloomberg News explains. "Created in 1968, it measures the likelihood of insolvency by evaluating earnings, assets and capital."

Recent trading action in the financial sector illustrates a similar enthusiasm for speculative issue. During the last 30 days, the bluest blue chips of the financial sector have failed to gain any new ground. But during the identical timeframe, the shares of the sickliest companies in the finance sector have been soaring.

Clearly, speculation is in vogue...

The VIX Index tells a similar story. Because the VIX is based on real-time option prices, it provides a useful "real-time" glimpse into the collective investor psyche. Known as the "Fear Gauge," the VIX correlates with the ebb and flow of investor anxiety. A high VIX reading indicates widespread fear among investors, whereas a low reading indicates a pervasive lack of fear.

At the moment, the VIX Index is quite low, which means that investors are feeling quite confident. As a contrary indicator, that's probably not a good sign. And as the nearby chart illustrates quite clearly, low VIX readings tend to correlate with important peaks in the stock market, while high VIX readings tend to correlate with important lows.

None of the stock market "internals" that we have highlighted in the charts above guarantee a market selloff. Nor do the financial travails of Tarot Card readers and coke dealers prove that the economy is much worse off than most investors imagine.

But when troubling stock market indicators begin to interact with disappointing economic data points, the stock market sometimes stops going up.

Eric J.Fry has been a specialist in international equities since the early 1980s. A professional portfolio manager for more than 10 years, he wrote the first comprehensive guide to American Depositary Receipts, International Investing with ADRs. Today he reports on Wall Street from California for the renowned Daily Reckoning email service.

See full archive of Eric Fry articles

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