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Dow Set To Enter Major Bear Territory

Wall Street sayings are worth paying attention to because you'd be surprised how often traders are watching them.

One of those sayings is the loose definition of a bear market: 20% is the point where a correction becomes a bear market, and 30% is the level where a mild-to-moderate bear market becomes a major bear market.

That 30% level is what we're watching here.

The S&P 500 had a spectacular rally in April after crossing the 30% threshold on an intraday basis (1553-1081) in March and retesting that level two weeks later.

The Dow will cross that same level at 8225 this morning.

So what are the odds of a rally here, with the futures way down (more than 400 points on the Dow) and panic everywhere? Pretty good, according to one market historian.

According to the historian, who has studied major bear markets in depth back to 1857, even the worst bear markets such as 1929 rallied more than 10% after the Dow fell 30%. The historian, who prefers to remain in the background, places the probability of a 10% or greater rally from this level at 93% or higher. If the Dow reaches its October 1998 low of 7400, that probability will increase to 97%.

If there is any good news here at all, it is that today is options expiration. That means that all those massive index arbitrage losses that we wrote about the other day must be settled today. That could clear one obstacle out of the way, but other pressures will remain, such as repatriation of foreign funds.

But even U.S. firms have likely been selling here, according to CNBC. Kudos to CNBC anchor Mark Haines for criticizing Wall Street firms for selling after telling everyone else to be patriotic. Index arbitrage and derivative losses no doubt played a significant role in this week's sell-off. Dow futures arbitrage trades were probably a stabilizing force over the last couple of years, but when they began September under water, they became a destabilizing force.

This market is deeply oversold. Fear is getting high. This, and history, raises the possibility that a bottom could be found soon. Levels to watch are the October 1998 lows: 7469-7632 on the Dow; 923-959 on the S&P and 1357-1419 on the Nasdaq.

One problem is that there are no significant cycle turns here; the earliest is October 11. There is, however, a minor turn today-Monday. Perhaps whatever low is made could be retested in October, perhaps with a minor lower low.

What is the worst-case scenario here? The greatest bear markets in history all share an interesting common trait: a 50% rally after a 45%-48% decline. That would make Dow 6500 or so a good place to bet on a significant rally, if the market gets that low.