They had been warned, but on a hot summer day the blue sky and magnificent scenery were spoiled by steam and ashes. When Mount Vesuvius erupted, a hail of pumice stones and ashes covered the city of Pompeii with 12 feet of volcanic debris. Nearly 5,000 people died on this day, the 24th day of August 79 A.D.

Warnings: sometimes they go unnoticed, other times they are disregarded due to lack of credibility or unwanted cause of inconvenience.

Use history to your advantage

When it comes to the stock market, you have to read between the lines to find red flags. In fact, the most relevant warnings are usually covered up by laughter and cheer. An entire investment model is built around contrarian indicators. For a good reason, Warren Buffett has been known to sell when others are greedy and vice versa.

Case in point, most warnings of a topping stock market issued in 2007 got lost amidst investor’s thirst for more profits and a prolonged bull market. Statistics show that investors went “all in” right before the market crumbled. Mutual fund cash reserves hit an all-time low simultaneously to the stock market’s all time high.

Shortly thereafter, a Mount Vesuvius like force hit Wall Street; investors experienced a modern interpretation of Pompeii. Portfolios are in ruins, covered in deep losses.

The market’s drop to new lows was preceded by warning signs just as the volcano’s eruption didn’t come out of nowhere and was expected by alert observers.

Deja Vu

Even as the initial $700 billion bailout bill was approved on October 2nd, 2008, we alerted subscribers of our ETF Profit Strategy Newsletter to get out of stocks or hedge holdings with short ETFs. In particular we recommended the ProShares UltraShort S&P 500 (NYSEArca: SDS) and ProShares UltraShort Consumer Services (NYSEArca: SCC).

On November 14th, with the Dow at 8,500, we alerted our subscribers of the following:  “The Financial Select Sector SPDRs (NYSEArca: XLF) already closed beneath its October 27th low. This should serve as a nice foundation for the next push down. Once the Dow breaks below 7,500, it’s time to lighten up on short ETFs”. Guess what, the Dow did drop to 7,445 on November 21st.

Why is this of significance? History may not repeat itself but it sure rhymes. While the S&P 500 (AMEX: SPY), Dow Jones (AMEX: DIA) and Nasdaq (Nasdaq: QQQQ) still remain above their November 21st low, the financial sector has broken to new lows yet again. On January 20th, the iShares DJ US Financial Sector ETF (NYSEArca: IYF), Vanguard Financial ETF (NYSEArca: VFH) and other financial benchmarks dropped to new all-time lows.

Short term indicators

Just as the rudder controls an entire boat, the financial sector has been steering the stock market. Financials spearheaded to new lows in 2008 and will do so again in 2009.
 

Another piece of the puzzle pointing to a break of the November lows is the non-confirmation within the Dow Jones family of averages. The Dow Jones Transportation Average (NYSEArca: IYT), the oldest index still in use, dipped to lower lows while the Dow Jones Utilities Average and Dow Jones Industrial Average remain above.

According to the Dow Theory, a non-confirmation of lows (or highs), in particular between the Industrial and Transportation average carries a negative connotation. A similar non-confirmation happened weeks before the November lows.

Despite negative forces pulling on the market, a quick glance at the chart reveals that Dow 8,000 has proved powerful support. All four dips below Dow 8,000 (Nov. 19, Nov. 20, Jan. 20 and Feb. 2) were followed by a push above this support level. Obviously the market views Dow 8,000 as important.

On Wednesday, once again the Dow closed just below 8,000 while the S&P 500 and Nasdaq remain above their respective support shelves of 800 and 1,500. This non-confirmation of the major indexes is another bearish divergence. A convincing close below support of any of the major index should kick the door wide open for further declines. The Dow will likely lead the way.

What is the long term trend?

So we know what the stock market's short term direction is but what about the long-term? Will the market bottom in 2009 or will we see further Great Depression-like losses? 

If you want to buy a car, you look at the Kelly Blue Blook or auction prices to ascertain a car's true value. How can you find out whether the stock market is 'cheap' or 'expensive'?



What does Dow 8,000 really mean? Nothing! The Dow, or any other stock market index, measured in inflated U.S. dollars can't serve as a trustworthy point of reference.

To find out the true value, the Dow has to be benchmarked against a real currency, true money. The only real 'money' is gold. How much is the Dow measured in gold worth today compared to other stock market lows?
 
Other reliable long-term indicators include dividend yields and P/E ratio’s. A comparison of current dividend yields and P/E ratios with historic bear market lows shows whether the stock market is over or under valued.

The December issue of the ETF Profit Strategy Newsletter compared the Dow's current value in gold and the Dow's current dividend yields with historic bear market lows. The results are truly astounding.

A common sense analysis of a composite indicators has kept our subscribers safe from the recent 30% drop. Every issue of the ETF Profit Strategy Newsletter provides a reliable short, mid and long-term road map to navigate today’s tough environment successfully.

Just as you can’t prevent a volcano from erupting, you can’t prevent the stock market from collapsing. However, you can heed the warning and prepare for what lies ahead. Is your portfolio up to par?

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