Following Monday’s Flash Alert about the 50% potential for a Crash, the market made a dramatic turnaround yesterday. Actually, it was the biggest one-day gain in the Dow Jones Industrials since 2002. So was I wrong? Maybe, but it could be “Or What” until we see the dust settle and the S&P 500 stay above 1326.

In Monday’s Flash Alert, I wrote:

“So maybe I am the one getting shaken out this time, just before the delayed rally begins. But that’s not the way to bet until the market itself tells us it wants to reverse and go up.”

So, has the market spoken? To determine this, we need to look at what really happened yesterday, and what to look for to tell if Tuesday’s rally was just a sharp, countertrend rally in what is about to turn into a bear market and a recession, or if it was the first leg up in the market’s run to new highs, with a couple of slow growth quarters thrown in instead of an official recession. Along with discussing this, I’ll also cover what to do with protective puts or the UltraShort S&P 500 ProShares (SDS) exchange-traded fund that I recommended Monday morning.

First, let’s take a look at what happened in the market yesterday. A 416-point upswing in the Dow Jones Industrial Average, the biggest rally in points since July 29, 2002, and a 47-point move in the S&P 500 on heavy volume cannot be dismissed casually. The way that the rally unfolded was also very positive: It started with an opening salvo that ran up to 1310 on the S&P 500, followed by a test back down that got to 1286, and then the blistering rally into the close. Some commentators think that the Plunge Protection Team was behind the initial rally, and then short sellers drove the second big move up later in the day. I doubt that the Plunge Protection Team had to do a thing — I’ve talked recently about how negative sentiment has been, how much cash is on the sidelines and how high short interest is. That was plenty of fuel to drive yesterday’s action after the Fed came up with a $200-billion loan program to save the banks and stockbrokers, by letting them post sub-prime mortgages at face value as collateral.

While this program bails out their Wall Street buddies, the Fed plan does nothing for falling consumer and business spending, and it may even cause the slow-moving Chairman Bernanke to cut only 50 basis points from the Fed funds rate at the March 18 committee meeting. With the two-year Treasury note around 1.5%, the Fed funds rate is still 150 basis points too high. Bernanke has been behind the curve all the way, and until yesterday, another 75-basis-point cut was in the cards. Now a 50-basis-point cut is more likely, but it still leaves the Fed funds rate too high. Bernanke is trying to substitute a targeted program to unlock the mortgage market for another big general decline in interest rates. While what he and the other central banks have done will stop the collapse in the financial sector, I doubt that the firms that he is helping will suddenly open the mortgage spigot again. Most of the firms have far too many mortgages on their books, and their customers in turn have no interest in adding to their mortgage exposure.

The Fed’s program doesn’t even start until March 27, which will be too late to save some mortgage holders from getting margin calls and forced liquidation at low prices. Just like the tax rebate program, a sense of urgency seems to be lacking. To get the tax rebate, consumers have to file their 2007 tax return. Why weren’t the rebates based on 2006 returns, and sent out right away? Government “thinking” often baffles me.

So following the Fed’s announcement of the $200-billion loan program, yesterday’s rally ensued and almost wiped out the prior three days of losses. But until we see that solid S&P close over 1326, no one can say that the decline is over. It was interesting to see such a big rally, including the 200-point gain on the oil-dependent Transportation Index, on a day when oil prices spiked to another new record at $108.75, squeezing consumers just a little bit more. Consumer spending is 70% of GDP, but the Fed’s loan program doesn’t provide any money to households. Credit card companies are cutting limits and raising interest rates, while banks are raising lending standards. At the same time, home values are falling, income growth is slowing, and the amount of jobs available is shrinking. There’s nothing in this plan to turn those drivers around — this is a Wall Street bailout, simple as that. Where is Eliott Spitzer when we need him? Oh, right…

The Fed hopes real buyers will show up today and for the rest of the week. If they do, the S&P 500 will breakout over 1326 and that will be the time to sell protective puts or the SDS. I will send you another Flash Alert when I see the market likely to close over, say, 1329.

But if the real buyers sit on their hands and sellers take this opportunity to raise cash at a higher level, then yesterday’s up move was just another typical sharp counter-trend rally, and the markets will be heading much lower. So, here’s what to do in either of those situations:

• If the S&P rallies and looks like it will close solidly over 1326 (I usually allow about three points of leeway), sell your protective puts or the SDS; If the market retests back down to 1326, perhaps around the March 22 turn date, that would be a low-risk entry point to start buying stocks again;
• If you don’t own any protection, don’t do anything until you see which way the market breaks;
• If the S&P rallies today and then falls back from 1326, hold any protective positions you have, including cash;
• If the S&P breaks 1270 and you don’t own any protection, you might want to think about purchasing some.

As I said on Monday, breaking 1295 and then 1270 probably means a quick trip down to 1180. I think the whole down move could come in one day, with the Dow falling over 1,000 points. The drop from 1255 — the spike low in the futures market on January 23 — to 1180 could come in one or two hours.

But if the S&P hits resistance at 1326, falls back to retest 1270 and then rallies sharply, that would be a triple bottom at 1270 and one of the best buying opportunities in years. So as you can see, it’s a tricky period for investors, and you can expect a lot of Flash Alerts for the next couple of weeks.

Again, as I said Friday and Monday, if you are a long-term investor and can ride it through, you don’t have to do anything. After March 24, as worries about the credit crunch and a recession fade, I expect our stocks to lead the broad market in a strong move up into an April 2009 top.