The Dow Jones Industrial Average ($INDU) has reclaimed the psychologically important 10,000 level. So is this the first leg of a new bull market? Should we expect the Dow to continue rising, perhaps to its old high above 14,000? Or maybe there will be a sharp snapback that will send the market spiraling down to its March lows of 6,547.

History suggests three basic possibilities (see accompanying chart).

1. A return to a Bull market, similar to the 1990s market after the 1991 recession.

2. A Bear market rally which fizzles out, retesting the recent low and then rising and falling in range-bound trading for years, similar to the 1970s.

3. A Bear market rally which runs out of steam, leading to new lows, akin to the sharp rallies in the early 1930s which led to new lows in the Dow.

Though the trillions of dollars in government intervention--bank bailouts, the $787 billion stimulus, cash for clunkers, etc.--have supposedly lifted the economy out of a recession, the stock market will eventually reflect the health of the non-government economy. If that is weak, then the soaring profits that power a true Bull market will be hard to come by.

For this to be a resumption of the Great Bull Market that ran almost uninterrupted since 1981, some engine of real economic growth must come to the fore. As has been noted by many analysts, recovering corporate profits have resulted not from growth in revenues but from clear-cutting expenses--largely through layoffs and other reductions of headcount which have increased unemployment.

While "less bad" is certainly better than "getting worse," a leveling off of slowing sales across the board should not be confused with actual engines of growth firing up.

For instance, much of the blip up in housing sales can be traced to bargain hunting; indeed, up to two-thirds of all sales in bubble-bust locales are of deeply discounted distressed properties. Other sales can be attributed to the Federal government's $8,000 credit for new home buyers and the Federal government's support of the mortgage market via FHA and Ginnie Mae.

Any market that is so dependent on government credits (giveaways) and loan guarantees is suspect: What happens when the largesse is withdrawn? Alternatively, what happens if the largesse can never be withdrawn lest the economy slide back into recession?

The hoped-for answer is that "organic demand" (that is, demand not generated by government stimulus and giveaways) will arise once this government-supported recovery takes root.

But where exactly is the engine for real growth? Various "leading indicators" have risen sharply off the lows set earlier this year, but how much of this is due to the trillion-dollar borrow-and-spend of the Federal government is hard to gauge.

From a big-picture perspective, four conditions act as roadblocks to an organic rise in demand and sales:

1. The foundation of middle class wealth--housing--is still way down from its peak. This means the collateral to back up new debt has been severely reduced. One-third of all homeowners with mortgages are "underwater," owing more than their home is worth. With millions of distressed homes being held off the market in "shadow inventory," then the belief that home values are set to rise faces the headwinds of supply and demand.

2. Credit markets are still impaired. Lending is down as banks are busy writing off bad debt and anxious not to add to their losses with new loans which could go bad.

3. Since 70 percent of the U.S. GDP is private consumption, and much of that has been based on ever-rising debt, then the loss of collateral/assets and the decline in credit availability means the free-spending American consumer is restrained by two handcuffs.

4. Baby Boomers, 65 million strong, are facing the unpleasant necessity of cutting back spending to save for retirement and pay down debt. This is a change in generational values and perception, not just a temporary dip in spending.

Even if we believe the leading indicators, history suggests markets often retest their recent lows before catapulting higher--as if participants can't really trust the advance until it's bounced off the low point decisively a second time.

So if history is any guide, if this is indeed a new Bull market, then stocks should dip in a modest retrace--the S&P 500($INX), for instance, might drop from near 1,100 to around 950-and then resume its climb.

Or, as occurred in 2002-2003, the markets might drop all the way back to their March lows before starting a sustained climb.

If stocks do form a "double bottom," retesting their recent lows, that's a healthy signal. But if the economy is in a structural malaise akin to the 1970s, then we can anticipate the stock market acting like it did in the 70s--trading up and down within a range, essentially going nowhere for the "buy and hold" investor.

In the worst-case scenario, the destruction of wealth and credit is so severe that the economy slips into a downward spiral in which business losses lead to more job cuts which lead to lower sales which leads to lower tax revenues and so on.

This is not as far-fetched as many believe. After all, U.S. households lost about $12 trillion in wealth in the past two years; compared to that sum, the Federal government's $787 billion in direct stimulus looks fairly paltry.

Yes, the Fed and Treasury have pumped trillions of dollars into the banking sector--estimates of all the guarantees and backstops extended to the credit markets run from $11 trillion to as high as $23 trillion--but this money is not flowing to households, so it is not offsetting the stupendous loss of personal wealth.

Dow 14,000 or Dow 6,000? History suggests a retest of Dow 6,500 may be a typical pattern after such a severe drop. From there, the future trend could follow one of three historic patterns: either the market climbs back to 10,000 and then runs up to the old highs at 14,000, announcing a new Bull market; or it trades sideways in a 1970s-type directionless zig-zag, or it rises to a lower high (topping out below 10,000) and then drops to a new low.

Nothing is guaranteed, so we'll just have to be mentally prepared for any of these options to play out.

Charles Hugh Smith writes the Of Two Minds blog and is the author of numerous books, most recently "Survival+: Structuring Prosperity for Yourself and the Nation."


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