Have we seen the bottom? Is it onward and upward? As I start this e-letter, the S&P and DOW are trying to top their recent highs. Will the S&P go through the 1250 resistance level? Is my short trade in jeopardy? Is it time to become a bull?

I will become bullish once again, but not yet, fellow traveler. While I cannot see around the Curve In The Road, I can read the warning signs. They keep telling us to watch out for bear traps.

First, let's go to my Investor Sentiment numbers and see why I think so.

Overall Investor Sentiment is still a red-hot 88 and has been trending up the last week or so. Looking at just that number might make you think we are getting ready to launch into the next phase of the bull market. But looking into the details yields a different picture. (This number is an average of the last few weeks.)

When we dissect that number, I see weakness. First, let's look at our institutional investors: The Big Boys. Last week, after the rate cut, they jumped back in big time. For the next two days and with record volumes, they bought with both hands. All by themselves, they boosted the sentiment numbers about 5 points.

It did raise my eyebrow when I saw the daily runs for those two days with the large investors coming back into the market. I knew, if they stayed, that would be quite bullish for the markets, and we are now short the market. Was I being set up for the bull market to gore me?

Sure enough, this week The Big Boys are going back to their AWOL status. Once again, they are off 25-30% of their usual trade participation. Those that remain are schizophrenic. One day they will be very bearish and the next wildly bullish. There seems to be a lot of re-positioning and second-guessing going on in the upper floor offices of The Big Boys.

The buying is coming from small and medium size investors who are buying the dips and responding to rate cuts. If you are a bear, this is good news. Though I think it is sad, as I suspect a lot more people will lose a lot more on Cisco and others. More about the psychology of this group later.

Secondly, the Sentiment Percentage Uptrends Index is still in retreat. It is now 21.5 and dropping. This is the percentage of stocks which show positive trends in sentiment, momentum and other variables. As I have said, this is the group hitting on all 8 cylinders. Typically, when this Index starts down, it will keep dropping until it gets to the mid-to-low teens before finding a bottom. We have some way to go to get there, which means this market is nowhere near a bottom.

While it is not impossible, it would be highly unusual for a new bull market to start from such high overall Investor Sentiment numbers with a falling Sentiment Uptrends number. Long-term secular bull markets start when sentiment is low and rising. While obviously Sentiment can rise from here, we are already red-lining.

Stock market watchers keep talking about "capitulation." By that, they mean they want to see enough investors throw in the towel so that all of the selling is out of the way. It is an old cliche, but markets go up when there are more buyers than sellers. In bear markets, until all the selling is out of the way, it is hard to launch a meaningful and sustained rally.

Investor psychology changes in bear markets. The longer we go without getting to new highs, the more frustrated and worn out investors get. It just becomes hard to keep the faith when your account keeps dropping. Instead of buying the dips, they start selling the rallies. Forget the cheese, get me out of the trap.

We look at scores of indicators, averages, and ratios every day. Talking this afternoon with my mentor, David Levin, who has been following this data for 30 years, we were both impressed with how long some of the ratios have held up at very high levels. Many of our indicators are 9 1/2 months pregnant and ready to drop. Like a baseball player on a hitting streak, the longer it goes, the more likely it is to end. I think we are getting close to where investors get exhausted. It will not take too much to make another significant group throw in the towel and send us on the next leg down of this bear market. If history is any guide, we are a long way, in terms of both time and price, from the bottom.

If bull markets climb walls of worry, then bear markets slide down a slope of hope. (I think I just made that up, but I may have read the slope of hope thing somewhere a few years ago - the mind plays tricks.)

In order to see a new bull market, we need to see some bottom to the earnings deterioration that is becoming epidemic. Ultimately, except in bubbles and/or stock manias like we have been in for about 4 years, stocks are priced on the ability to make a profit, either now or in the future.

Historically, the average ratio of stock price to earnings has been about 15. Today it is over 22. As earnings keep dropping, either the price of the stock has to drop or the P/E ratio will rise. Typically, the stock price will drop.

But this market is not typical. Investors seem to keep hoping the worst is over. They believe that the pixie dust of Greenspan's rate cuts, coupled with their happy thoughts, will make this Peter Pan market fly. With a few more rate cuts, things will get back to normal and they will recover what they have lost in their stock portfolios.

With each failed rally, more and more investors throw in the towel. With every earnings disappointment and consumer confidence drop coupled with rising unemployment and reduced consumer spending, more and more investors begin to head for the sidelines.

Not until we see our overall Sentiment Index number drop to 50 or below will we have capitulation. And until we get to that magical point, we will not have a bottom.

Bond Update

Have we seen the bottom of the bond market? Is the rally starting?

Today, the US government stepped in and bought bonds, thus driving down yields and bond prices up. This is part of the natural process of surpluses, as I have been saying. It is one of the major reasons I am so bullish on bonds. I still expect more volatility, however.

There is good news/bad news for bonds from the Land of the Rising Sun and Falling Yen. The good news is that Japan has gone with a new reform-minded Prime Minister. If he follows through, it will mean short term pain for Japan, but with a realistic hope for real improvement in the future. But the problem is there is an election coming up in a few months. You can bet that there will be no real medicine until after the election.

What can Japan do? Lower rates? Expand the money supply? Been there, done that, didn't work. A number of commentators, including favorite guru Greg Weldon, think the only avenue left is for them to purposefully let the Yen drop against the dollar. Since every other country except Europe is in a race to de-value their currency against the dollar, they would just be joining the parade and keeping the currency in line so as to try and keep exports to the US competitive with the rest of the world.

That would be good long-term for bonds, as it means foreign investors, especially the Japanese, will want dollars.

Europe Faces Some Tough Decisions

From several sources, it looks like Europe is starting to see some trouble. Last year, the conventional wisdom was that Europe would do better than the US as things slowed down, due to their huge internal markets, an increased ability to compete globally and a weaker currency vis-a-vis the dollar that put them in the "cat-bird's seat."

That perception is changing. Many countries in Europe, especially Germany, are beginning to show signs of inflation. The overall European economy is slowing. What is a Central Bank to do? If they do cut rates to help their economy, they may spur more inflation. As opposed to the US, where surpluses, fundamentals and government policies allow Greenspan to cut rates without a serious threat or re-igniting inflation, the European Central bank and the various governments are at odds, and indeed are huffing and puffing at each other. I think this will just be the beginning of finger pointing. I also think they cut rates and risk inflation. The Central Bank will blame it on the various profligate governments.

Europe is on a road to that most malignant of all economic diseases: stagflation.

The Rest of the World

Korea is on the critical list, and could get worse. Watch the news in the next few weeks and see if the world wakes up to the crisis brewing there. As mentioned last week, Argentina is a potential land mine. Brazil is suffering. Turkey is almost DOA. Everywhere we look, I see problems. For every bright spot like Ireland, there are five basket cases. I could make a list and go into details, and may, in some future letter. But the point is that in a global economy, when so many of our trading partners are hurting, this is NOT a good climate for the multi-nationals. It is especially not good when the dollar remains strong, as it hurts the overseas sales and profits.

Where are we going to see the source of new and higher earnings? Companies are aggressively cutting costs and employees in an effort to keep their margins and profits up. But cutbacks in one sector trickle down throughout the economy. Employee lay-offs affect consumer confidence.

We are on the verge of a global recession. We may be there now, although no one wants to say that word. This is not 1998 when the Asian tigers took a few hits. This is everywhere, and it comes at a time when the American consumer is not in the mood to bail out the rest of the world's economies.

Cheerleader Alert!

Finally, this tid-bit from Weldon's latest letter which intrigued me. The talking heads and cheer-leader analysts made a big deal out of the month-to-month rise in durable good sales. I was kind of surprised by that number, as I keep telling you things are getting weaker. But leave it to Greg to actually read the report (quote):

"US Durable goods orders rose MUCH MORE than expected, posting a 3.0% month-month growth rate. However, orders in the transportation sector supported the headline data, as we note the yr-yr performance in the following sectors ---
--- Total New Orders ... down 7.0%
--- New Orders ex-defense ... down 9.3%
--- New Orders Primary Metals ... down 15.0%
--- New Orders Machinery ex-electrical ... down 1.7%
--- New Orders Electrical ... down 17.3%
--- New Orders Transportation Equipment ... up 2.7%

Further, we note the support derived from the 45.6% spike in orders for civilian aircraft ... and a whopping 62% rise in Defense Orders, as the US military placed a sizable order for new tanks, boosting orders by several billion dollars. We looked for, but could NOT find a reading for durable goods orders ex-tanks. (By that Weldon means what happened to durable goods without tanks [except tanks] adding to the total.-JFM)

Finally, in keeping with our macro-theme on falling capital expenditures (as we detailed yesterday) ... we note the orders for non-defense capital goods, excluding aircraft, as this serves as a proxy for forward capital expenditures. This order series revealed a 0.7% monthly March decline, and are now declining at a rapid 4.2% rate."

MY macro-theme of late has been the effort of cheerleading analysts and talking heads to talk this market up. They trumpet every bit of good news and tell us the bad news is already factored into the price of stocks. I am telling you that if a stock is at a P/E ratio of 30-40 or more, which many tech companies are, there is still plenty of potential bad news that has not yet been factored in.

I am watching this second rally attempt fizzle as I hit the send button to my daughter and get ready to go into a meeting. Bet it goes lower before the close.

Remember this: rallies fizzle in bear markets as investors look for opportunities to get out. It may take weeks or a month or two to really wring out the patience and hope of investors, but this market is going south.

Today, my wife and I get to again experience the joys of moving to a new home. We are once again leasing, as I think interest rates and home prices could be much lower in two years, when my wife and I hope to purchase a home and not move again for a LONG time. I think it is possible that someone will offer to lend me money for 30 years at 5% or better, just as they did my parents. I intend to take them up on their offer. It's just part of the cycle, fellow travelers.

Your already feeling his sore muscles analyst,

John Mauldin

P.S. If you like my letters, you'll love reading Over My Shoulder with serious economic analysis from my global network, at a surprisingly affordable price. Click here to learn more.

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