That the market would eventually pull back after rallying 40% off the lows was the easy trade. However, in the coming weeks investors will need to decide if this is indeed the start of a new bull market or a bear market rally.

I am in no rush to make a decision as I believe that even if this is a new bull market that this correction has further to go. After a two month 40% run, I would expect a correction that lasts at least a few weeks.

When the initial burst off the bottom in 2003 occurred, there was a large sentiment shift, similar to what we are seeing today. At the time, the US invaded Iraq and with each military victory the market shot higher. This time around we have the stress tests, which are proving to be an even easier challenge than Saddam Hussein was. It seems that everyone remembers 2003 and believe they know what happens next.

While the current period bears some similarities to 2003, the differences are far more prominent. In 2003 companies were announcing large buybacks and we were at the nascent stages of an LBO boom. Currently, companies and insiders are selling stock into the market at a pace never seen before. Back then we were at the early stages of a real estate and credit bubble. Every day new methods were being invented on how to turn one's house into an ATM. Today we have massive over capacity in real estate and consumers are deleveraging. Back then corporate taxes were being lowered, while Barack Obama is planning on closing tax loopholes that will likely result in a 4% reduction in corporate earnings.

Regardless if one believes that this is a bear market rally or a new bull market, a correction seems forthcoming. For the past six weeks the market has only had brief pullbacks that lasted one to two days. The S&P 500 now sits approximately 30% off its lows and has not taken a breather. There is a long list of evidence pointing to a correction beginning this week.

• The 30 Day Moving Average of the NYSE Advance Decline Line will be maximum overbought by the end of the day Tuesday. This is an intermediate term indicator. Peaks in this indicator usually come close to market peaks.
• Insider selling has picked up steam in the past week. This will likely continue as companies report earnings and lockup periods end.
• There was approximately $9 billion in new stock issued in the past week led by the "smartest guys", Goldman Sachs (GS). There is no reason to believe the issuance will stop. Do you want to take the other side of their trade?
• Sentiment surveys are showing that bullish sentiment is high. The Investors' Intelligence bulls are at their highest since June 2008. After this week's rally the numbers will likely be even higher.
• Options expiration often helps perpetuate rallies. Now that expiration is in the rear view mirror this clears the way for a decline.
• This rally will be six weeks old (30 trading days) this Tuesday. The November rally lasted exactly six weeks.

Disclosure: Short SPY

The S&P 500 rallied over 20% from its lows two weeks ago to its highs after the Fed announcement. That rally was the first phase of this bear market rally. We are currently in the second phase, which is a consolidation of the gains. This consolidation should be followed by the culminating rally or the third phase. On the chart below I labeled the November rally by phases (click chart for larger image) .

Throughout history, the best time to buy stocks has been when valuations were low. No economic or fundamental variable other than valuation was predictive of long term stock returns. By definition, in order for valuations to be low the consensus must be that stocks are unattractive. If the consensus were that stocks were attractive, everybody would be buying and valuations would no longer be low. Generally, when everyone is bearish there is economic turmoil and uncertainty.

Today's market valuation is among the lowest in history. There have been cases where the market has traded lower but longer term returns from current valuation levels have been very satisfactory. I have been scaling into the market with the intent of becoming fully invested if the S&P 500 reaches 600, which would be very close to the most extreme valuations.

There is a new type of math circulating around Wall Street. It involves taking the current earnings of the S&P 500 and applying a single digit P/E ratio to it. The result is lower and lower price targets for the S&P 500. This is the polar opposite of the internet bubble where as stocks rose higher, price targets were raised.

The logic being used in this exercise is flawed. For instance, AIG (AIG) is scheduled to report a 60 billion dollar loss on Monday. The combined yearly profits of ExxonMobil (XOM) and Microsoft (MSFT) are 60 billion dollars. If you combine the three companies together they have no profits. Applying an 8 multiple to them yields a price of zero for the three companies. Are Microsoft and Exxon worth nothing because AIG reported a huge loss?

My favorite measures of sentiment have always been the option ratios. Sentiment surveys measure what people are saying, but option ratios measure what people are actually doing. Currently, the option ratios are saying that we are much closer to the end of this rally than the beginning.

Last week, the Treasury announced that it would purchase 600 billion dollars in Fannie Mae (FNM) and Freddie Mac (FRE) debt. Generally, the Treasury would need to borrow money by issuing bonds to finance such a purchase. However, the Treasury announced that the purchases "will be financed through the creation of additional bank reserves." The English translation of that is they are printing money in order to buy GSE debt.

In large part that is why Treasuries have been rallying. They are buying long term debt without issuing any long term debt, reducing the supply of long term debt on the market. There are two schools of thought on what the consequences of this will be. Some say that during the next economic expansion we will have hyper inflation as a result of the money printing. The other school of thought is that the deflationary forces are so strong that this will not make a difference.

Below is a graph of the Put-Call Ratio (10 Day Moving Average of the CBOE Put-Call Ratio). When the line is at the top of the page there is heavy put buying, which indicates fear and is usually seen at market bottoms. I marked the peaks in the ratio with a red X, which roughly coincided with this years major market lows. As you can see we are nowhere near prior peaks of put buying and have probably not put in a good bottom.

click to enlarge

Ciena (CIEN) is a great example of what can happen to a stock in a bear market. The stock was already down from 48 to 17 before their earnings announcement (see conference call transcript). The stock was trading at 8 times next year's expected earnings when you exclude net cash. It seemed like the stock was already pricing in some sort of disappointment.

Ciena gave negative earnings guidance and the stocks is down another 25%. Ciena provides necessary equipment for internet providers to expand bandwidth. It is obvious that we are bumping up against our bandwidth capacity as both Comcast (CMSCA) and Time Warner (TWC) recently started cracking down on "bandwidth hogs", customers who use too much bandwidth. Even if they can get rid of the bandwidth hogs, eventually they will need to expand their networks as people watch more video on the internet. Ciena will be the beneficiary.

Before I outline what I think is wrong with the hedge fund industry today, I would first like to mention that some of the investors I aspire to the most are or were hedge fund managers. People like Michael Steinhardt, Steve Cohen, Julian Robertson, George Soros and Doug Kass. At the time these mangers started in the hedge fund business, they were mavericks who were fighting against the institution. The problem is that hedge funds have become the institution.

Twenty five years ago, hedge funds were not on too many people’s radar. Most people invested through mutual funds or brokers. The pioneers of hedge funds believed that there was a better way and made money by setting themselves aside from the crowd. Their successes brought much attention and popularity grew over the years.

A miserable quarter for hedge funds was capped off with a miserable week. The quarter saw the reversal of several popular hedge fund trades and the worst monthly performance since 2002. In the past week, the market did not move much with the S&P down 0.72%.

However, much of the damage for hedge funds was below the surface. According to Goldman Sachs, hedge funds are overweight the technology sector and net short the financial sector. Last week, the NASDAQ was down close to 2% and the financials rose over 3%, putting further pressure on hedge fund performance. The news of a Lehman (LEH) resolution might help perpetuate the short covering rally in the financials. There is now potential for further redemptions, which is a wild card. I will not try to predict what will happen but will look to take advantage of a disconnect if it does occur.

Michael Steinhardt was possibly the best hedge fund manager of all time, with an enviable track record. When analysts brought an idea to him, he required that the idea be different from the market consensus. Of course, the idea had to have solid logical backing as well. He called this variant perception.

I follow this tenet religiously. Every time I have an idea, I try to figure out what the consensus is. If my idea is in line with the consensus, I drop the idea. If everyone agrees with me, what am I bringing to the table? Even if I turn out to be correct, my idea is probably already priced into the stock.

Which is a safer stock to own right now, Wal-Mart (WMT) or eBay (EBAY)?

The knee jerk response would be to answer Wal-Mart as it just sounds safer.