"Hope for the best, prepare for the worst." Has there ever been better advice than this little gem? Be optimistic, hope for good things to happen. But don't get caught flat-footed or unsuspecting when the bad stuff happens. This pretty much says it all. And rarely has this advice been more relevant than it is today, as the world economy seems to be circling the drain, more jobs disappear daily, angst grows among the masses, the stock market keeps working ever lower while our esteemed politicians work frantically to "fix" the problems (also known as "pouring gasoline on a raging fire").

The Good News

There is some good news and some bad news here. The good news is that the stock market is clearly due for a "pop." Notice, please, that I did not say "major bottom." Truth be told, I'm not too good at predicting such things. Nevertheless, in the short run the market is once again getting oversold, yet continues to hold above 2008 lows. As long as these lows hold, the possibility for a surprisingly sharp (albeit potentially short) upside reversal remains. Historically, February has been a decent month for energies, financials, retailers and gold stocks. As you can see in Chart 1, despite the daily gloom and doom in the headlines, energy, financial and retail stocks are presently holding above their 2008 lows and gold stocks have been rallying. So don't be surprised if we see a "pop" to the upside in these key - and terribly beaten down - sectors.

Chart 1 - Key sectors attempting to hold above support
click here for larger view

What we really need now is a "catalyst." What might that be? At this point it will likely be something innocuous and fairly unexpected. With t-bill yields at about 0.25%, we can be pretty certain that the catalyst won't be a cut in interest rates. The cynic in me says that one thing that might help would be if the new administration would stop threatening to throw "greedy" business leaders into jail and to confiscate their money. Just a thought. Yes, I have gotten the memo that in the new order, all businessmen and (let's be politically correct here) businesswomen are "greedy" and that big business and corporations are "evil." And yes it is always great fun to demonize the dreaded bogeyman, "big business." Still, the fact remains that it's awfully tough to have a functioning capitalistic economy without them.

A Few Relevant Questions

In a supposedly desperate attempt to save domestic jobs, certain U.S. politicians are presently clamoring for some sort of trade protections, starting with steel. From a populist point of view I can see the attraction; nevertheless, as a student of markets and economics all I can really say is "Wow, does no one study history anymore?!" That would seem to be the case as it is an undisputed fact that the Smoot-Hawley Act passed in the 1929 was a defining piece of legislation that helped shove the economy over the edge from a recession into a full blown Depression. To fully appreciate the potential danger of enacting protectionist legislation consider that (as pointed out by Thomas Donlan in Barron's this week) following the passage of Smoot-Hawley, U.S. imports fell 66% and exports fell 61% between 1929 and 1933. I know that we are all very busy panicking and everything, but can anyone really look at these numbers and still think that trade protectionism will help our present economy to rebound? And if so, could someone please explain exactly how? Also, please note that if the explanation includes the words "it will be different this time," I just may be compelled to punch someone.

Now I do understand that in recent decades we have been inexorably shipping our manufacturing base overseas. And yes, I understand that we have paid a high price for this in terms of lost manufacturing jobs. And yes, I agree that in many ways this is unfortunate. Still, at this point the whole "world economy" thing is kind of a reality. Our economy is very deeply intertwined with the economies of a whole lot of other countries. So trying to unilaterally undo any or all of this and in the process risk a major trade war with our primary trading partners - with the attendant collapse of imports and exports - seems a bit, how shall I say, "disruptive."

Manufacturing jobs are great, but the relevant question here is, do we want to start paying a lot more for goods that we presently import, by "forcing" "greedy" and "evil" corporations to make those products here in the U.S., in the process using more expensive U.S. labor? Just asking. Likewise, can anyone please explain to me how a trade war - whereby we import less, export less and pay more for goods manufactured here due to higher labor costs - is going to help "right the ship?"

Wait, I've got it! What if the government steps in and forces U.S. companies to manufacture here in the U.S., to hire only U.S. workers and to accept less profit by selling their goods at forcibly lower prices?! Ah, free enterprise, we hardly knew ye!

Now for the Bad News

I have mentioned at times in the past that my crystal ball broke a long time ago. So my ability to "predict" the future is, well, about the same as everyone else's. Still, I do follow trends and have often noted the cyclical nature of the financial markets. A couple of historical tendencies are presently flashing foreboding warnings about the overall prospects for the stock market in 2009.

As I discussed last week (Kaeppel's Corner: The JayNewary Barometer), my JayNewary Barometer registered its most bearish possible reading of "0." This occurred because the Dow Jones Industrial Average showed a loss during the first five days of January, the last five days of January and the month of January as a whole. Table 1 displays the January 31^st through December 31^st performance for the Dow during the seven previous years that witnessed a JayNewary Barometer reading of "0."

Table 1 - Dow performance following previous occassions when the JayNewary Barometer readings of "0"

Just for fun I put together an equity curve showing the growth of $1,000 invested in the Dow only between January 31^st and December 31^st of the years listed above. Those results appear in Chart 2. As it turns out, "fun" would appear to be a poor choice of words. "Ugly" might be a better fit.



Chart 2 - Growth of $1,000 invested in Dow only between January 31^st and December 31^st of years when JayNewary Barometer registered a reading of "0" (1957, 1960, 1974, 1977, 1978, 1981, 2008)

As you can see in Chart 2, it's not like the stock market doesn't rally on occasion between January and December if the JayNewary Barometer registers a reading of "0." But the overall downward trend is unmistakable.

The other warning sign of note was something I wrote about in my December 31^st article titled "Kaeppel's Corner: 2009, The Year of Investing Differently." There I highlighted research done by John Harris, a market historian and professor emeritus of accounting at the University of Tulsa. In a piece of very insightful work, Mr. Harris examined nine previous years during which the S&P 500 lost at least -8% during the fourth quarter of the year.

In a nutshell, after a fourth quarter loss of -8% or more, the Dow averaged a gain of about 10% during the early part of the following year before then plunging an average of -33% to its ultimate low for the year.

To understand the results in Table 2, consider the first line.

Columns 1 and 2: During the fourth quarter of 1929, the S&P 500 lost -28.9%.

Columns 3 and 4: Between 12/31/1929 and 4/17/1930 the Dow Jones Industrial Average gained +18.1%.

Columns 5 and 6: From the high established on the date shown in Column 3, the Dow plunged -46.4%, reaching a low on 12/16/1930.

Column 7: This left the Dow with a net loss of -36.6% between 12/31/1929 and 12/16/1930.

Table 2 - Results based on John Harris' research on Down 4^th Quarters

As you can see, in the past a poor fourth quarter has presaged market weakness in the following year. The Dow was down -19% during the fourth quarter of 2008. So far this year, the Dow rallied almost 3% on the first trading day of the year and has since plunged -12.2%. So far, so bad.

Summary

If the performance of the Dow in 2009 follows the precedents set in previous years following big down fourth quarters and/or years during which the JayNewary Barometer registered a reading of "0", then those investors hoping for a reprieve from the 40 to 50% decline already registered by the major market averages are likely to end up very disappointed. So here it is in a nutshell:

The market is extremely oversold and no one should be surprised if a sharp rally begins to unfold at any time in the near future. However, the real danger is that if there is a meaningful rally, then the "masses" will suddenly breathe a huge sigh of relief, as in "thank goodness that's all done with and now we can get back to the good times." Which would set the stage perfectly (albeit perversely) for one more major down leg that would shake investor's will and confidence to the very foundation. And which, ironically, could also mark a major bottom as the market starts to look forward to an economic recovery in 2010.

So be prepared to take advantage of a stock market rally if the market shows any signs of turning around. However, under no circumstances should you let your guard down. If in fact the market does rally at some point in the near future it may be an ideal time to lock in profits, or to cut losses, or to hedge your positions using option strategies such as long puts or collars.

Hope for the best. But prepare for the worst. As sage a bit of advice as ever.

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Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site