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Two Years Later, Bears Still Hiding in Their Caves

Like a card shark figuring out the right way to play a tough hand, the stock market bear is waiting for his bullish opponents to go all in before making a move.

With prices on a seemingly inexorable march higher, there seems little else for those betting against Wall Street to do but to wait until the rally has played itself out.

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That moment of capitulation—when the last pessimist has given up and decided there is nothing left to do but start buying—will be the point when the bull market created off the March 2009 lows will end.

“There’s always significant downside risk,” says Keith Springer, president of Springer Investment Advisory in Sacramento, Calif. “The risk will come when there’s over-optimism, essentially.”

Perhaps the most stunning part of the rally that has erased nearly all the stock market losses since the financial crisis is how deliberate it has been.

Rather than fits and starts, the move has come in a staircase fashion amid an improbable eight-month losing streak for inflows to US equity mutual funds that only reversed in the past month or so.

Because retail investors have returned to the market only recently, the rally could have even more room to run before the bears take over.

“There’s a lot of catching up to do. All that money that flew into bond funds the last two, three years, that’s not long-term investment money, that’s just lazy investors afraid to go into stocks,” Springer says. “There’s going to be a catch-up rally, and that’s going to be the top.”

The question for the bears, then, is when that happens.

The rally began on March 6, 2009 when the Standard & Poor’s 500 hit that ominous intraday low of 666. At the time, investors felt the economy was injured beyond repair and Obama administration officials, particularly Treasury Secretary Timothy Geithner, were under fire for not seeming to have a grasp on the depth of the problem or a solution to address the many woes bedeviling both Wall Street and Main Street.

Soon, though, the Federal Reserve would step in with two letters that became the greatest symbol of the rally: QE, which stood for quantitative easing and gave investors hope that the central bank would be there to backstop the market with liquidity.

Since then, the only meaningful retracement came from April through August of 2010, when the Fed’s original QE program ran out and the European debt markets caused worries of global financial turmoil.

With the second leg of QE winding down, some weary market bears believe the end also could be near for the stocks rally.

“The bears have been chased so far back into their caves that they’re afraid to come out,” says Kathy Boyle, president of Chapin Hill Advisors in New York. “They’re going to have to raise rates to control inflation. Short-term, they can’t do that. Rising rates are going to be bad news for any growth that’s happening. When you add up everything, there’s still a lot of bad news.”

Indeed, inflation seems to be the market’s greatest enemy now, even though few Fed officials are willing to concede that loose monetary policy is risking a broad-based price rise that will threaten growth.

Once those inflation fears turn to reality and the Fed is forced out of its easy-money position, the market likely will be hard-pressed to withstand a new reality.

“Is the bloom off the rose? I think it’s a very tired market,” Boyle says. “The risk-reward ratio is just not there for putting new money in at these levels.”

TrimTabs, a market research firm that closely tracks a number of sentiment and flow indicators in putting together investment recommendations, believes the date for a pullback is closer than some think.

“If stock prices keep chugging higher between now and early April and investor profits increase even further, a tax-payment induced wave of selling could happen a week or so before tax day, which is April 15 this year,” the firm said in its weekly analysis.

Analysts at TrimTabs remain bullish for now but say indicators such as $31.1 billion in insider stock selling over the past 60 days—the highest level since before the financial crisis began—indicate that storm clouds are just over the near-term horizon.

TrimTabs is advising clients to take positions in metals and inflation-protected bonds as a hedge against the storm brewing.

“If the stock market starts to sell off as tens of billions of dollars in equities and other assets are sold to pay taxes, portfolio managers sitting on huge profits could start panicking about a post-QE2 world,” the firm wrote. “The result could be a sharp drop in stock prices.”

How bad that will get is a matter of debate.

Sam Stovall, the chief equity strategist at Standard & Poor’s, said the firm has recently raised its price target for the benchmark S&P 500 to 1,400 yet expects a pullback of at least 7 percent in the near term.

One extremely bearish analyst, though, is backing off dire scenarios, at least over the short run.

Abigail F. Doolittle runs Peak Theories Research, a boutique firm in Albany, N.Y., and writes a weekly newsletter that has achieved some popularity in the blogosphere.

Not long ago, Doolittle drew attention for chart analysis ostensibly showing a looming inflation-induced drop for the S&P 500 to 425, which would be a 65 percent plunge from current levels.

While she still believes that hurricane is somewhere on the horizon, she says the near and intermediate term remains cloudy for bears.

“I still have that target and I still believe there’s an excellent chance that the S&P will hit some level in that area based on the technicals,” Doolittle says. “That’s going to reflect ultimately the potential fallout of what the Federal Reserve is doing.”

Nearer term, the S&P could correct down to “high triple digits” or the rally could carry it to new highs in the 1,550 range, she says. Ultimately, it comes down to whether the market can survive without the Fed.

“If the government steps away, will the market be able to run on its own?” she asks. “I don’t think anybody right now can predict which way that will go."