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WHAT THE MARKET WANTS: Oct. 2008

The bear awoke from its hibernation with a vengeance in September as market participants ran for the hills while the U.S. government went shopping.

Bailouts of Freddie Mac, Fannie Mae, and AIG gave an already skittish market still more to worry about, while it was trying to cope with the downfall of Lehman (seems so long ago), a slew of other financials on the seeming verge of extinction, an economy teetering on recession, and a general sense that things are getting worse, quickly.

All this prompted The Great Bailout, which on September 29 failed to pass the House of Representative and sparked The Great Blowup.

Oh yeah, that same day WaMu garnered the distinction as the biggest bank failure in U.S. history following a classic "run on the bank."

After the dust had settled amid a dearth of buyers, stocks posted one of the worst months on record. (The short selling ban on more than 800 stocks didn't seem to have helped much.) The market had already been in a steady and volatile decline for the entire month that was capped by The Great Blowup, resulting in a 777-point loss for the DJIA and second largest daily percentage drop ever for the S&P 500.

Stocks snapped back on the last day of September; otherwise, the numbers would have been even uglier. The Nasdaq, down 12.1%, fell the hardest while the Dow lost half of that (-6.0%) and the S&P 500 shed 9.2%.

The biggest loser was the Russell Midcap Growth Index, which plunged 15.4%. The least weak of the indices was the Russell Microcap Value Index (-4.7%), followed closely by the Russell 2000 Value Index (-4.9%). This huge performance gap underscores the continued dominance by value and the lower cap segments during the last several months.

In fact, despite the overall market weakness, the small-cap value segment is down "only" 6.9% year-to-date and actually posted a gain of 4.4% for the third quarter. This remains the safest place to be for investors. In fact, stocks with any number of value characteristics fared best in September, and we see no signs for this trend to end.

The overall market trend also shows few signs of letting up. The major indices are all down 25-30% since topping last October, and new lows continue to take out old lows while rallies continue to be met with renewed and vigorous selling. With the average bear market lasting about two years, we could be in for more pain.

What the market wants, it's not getting -- some semblance of certainty of where we'll be 6-12 months out. Without that, the market is behaving as expected.

Third quarter earnings could provide some relief. However, with the economy showing signs of deterioration and the contagion spreading across the globe, it doesn't seem likely. One thing to note is that panic is in the streets and fear has reached historic levels.

Bottoms are usually carved out during periods of all-out panic and fear, although these bottoms normally take several months to form. So the market is ripe for a countertrend rally, but downside risk remains high as the bear remains on the prowl..


Next update:  First week of November.