The DJIA closed at 13,211 today, down 146 points and change. Today’s sell-off is being blamed on troubles with American Home Mortgage (AHM), which is looking at liquidation and is now a penny stock. So the correction I prophesied in the past weeks is well and truly here. The DJIA is down about 800 points from its recent peak high.

I had noted in earlier articles in this blog and my MONEY newsLETTER that a correction was to be expected right about now, probably of 750-1,000 points on the Dow. And a correction is actually healthy if the bull market is to continue. That, though, is the $60,000 question.

No one, including me, knows when the next bear market will resume - or if it has begun. We all know that bull markets end, and we’re into this one over 4.5 years. Is it ending as we watch, or is this another correction before the market’s final lunge to a greater high (and then a bear market)? I suspect the bull has further to run, but at some point the “housing” chickens will come home to roost.

What most people don’t understand is that great bull markets are in reality built upon asset bubbles, which really are credit bubbles. Even going back to the Dutch tulip-bulb mania hundreds of years, they are built on credit bubbles. That is what happened in the 1990s bull, much the same as this one. Astonishing amounts of credit of all types have been sloshing around the planet. From the yen carry trade to the American housing bubble, the size of this bubble is almost incomprehensible. And it is ending. The popping of the credit bubble punctures the asset bubble… then the bear comes.

Bull markets sometimes end in a double top, but as in 2,000, it can hit a peak and fall a couple thousand points from there. In 2,000, tech and speculative stocks sold off hugely, with the bigger companies declining much more slowly. In fact, that is how bull markets build: the smaller stocks take off first, then the medium-sized ones, while the big stocks underperform, and eventually the big stocks take off, too, toward the end of the bubble. The big stocks really took off this year, some in 2006. Yet as the market made new highs this year, fewer and fewer stocks participated in the rise. The number of stocks trading above the 200-MA actually declined. But the amount of stock buying on margin hit all-time highs this year. This is all worrisome stuff, folks, not just a concern for worry-warts.

The credit bubble enabled homeowners to pull money out of their houses, and 75% of the growth in GDP the last few years - and most of the consumer spending - came from mortgage equity loans. That tap is pretty much shut off.

What would a bear market look like? Expect a decline of 20-25% from the market top. We’re talking about 3,000 points or more. If the current sell-off is a correction only, then no one should get bearish again unless the market is showing signs of unmistakeable robustness - large, medium and small stocks going up toward making new highs. If only the large stocks go up, this is a sign of flight to quality and not a real continuation of the bull.

Some industries remain strong - a good sign for bull believers. I suspect this sell-off is a correction, since not quite enough stocks are turning down, and because some industries remain strong. Still, like the soldier who puts his faith in God but keeps his power dry, covered call writers are well advised to take protective measures when the market starts tipping over - such as buying multi-month protective puts, which can be sold at a profit if the market recovers and exercised if it does not. Ditto for those who are not call writers but who are sitting on highly appreciated stocks.

In fact, I am so sure of a coming bear market, that I’ve decided to gear my next seminar in October to preparing students for call writing - safely and with extremely limited risk - in a falling market and managing trades profitably even when stocks drop. Of course, these strategies work just fine in good markets, too. I may even form mastermind groups from the seminar students to trade stocks in the bear market… something no one else has ever done, to my knowledge.

This entry was posted on Tuesday, July 31st, 2007 at 6:04 pm and is filed under Covered Calls, Markets/Economy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.