Stocks have rallied nearly 40% since the March lows. Many investors see themselves at crossroads; is it time to sell at current levels or should you hold out for more gains. The vote ,coming from 3 short and long-term indicators, is unanimous.
Ignorance is bliss. Sometimes we think that just because we don’t know something, it can’t hurt us.
Unfortunately, it doesn’t work that way with the stock market. Quite to the contrary, the market punishes the unaware to a large degree.
The 40% rally in the S&P 500 (NYSEArca: SNP: ^GSPC), Dow Jones (DJI: ^DJI), and Nasdaq (Nasdaq: ^IXIC) surely has been blissful. Higher beta indexes, like the Financial Select Sector SPDRs (NYSEArca: XLF) and Consumer Discretionary SPDRs (NYSEArca: XLY), have climbed even higher.
If you are getting too cozy with your portfolio holdings, keep in mind that new bull markets climb a wall of worry. As of recent, however, caution has been thrown to the wind. If this is not a new bull market, investors must ascertain why stocks have carried higher and how much upside potential remains.
Concern No. 1: Optimism
If something is too obvious, it’s obviously wrong. As of late, the media has been consumed with discussing the shape of the recovery. The possibility of another downturn is all but ignored.
By now, we should have learned that there is no such thing as a sure thing. Investors thought the stock market was safe in October 2007 and once again in January 2009.
In January, it seemed like the financial meltdown – which was kicked off by troubled AIG in September 2008 – had been handled successfully. A strong Santa Claus rally and the first five days of January revived feelings of optimism. On January 6th, the Dow topped at 9,175 and declined 30% in three months.
Previously, on December 15th, the ETF Profit Strategy Newsletter warned of the following: “Within the framework of back-and forth wiggle action, the Dow should claw its way past 9,150 (past 945 for the S&P 500). Optimistic sentiment, which should be more visible above Dow 9,000, will give way to further declines. These should draw the indexes below their November 21st lows.”
Investor sentiment has reached levels similar to those seen earlier this year in January.
Concern No. 2: Lack of conviction
There are different indicators that measure the conviction behind the market’s moves. Total volume, up/down volume (also called breadth), and advancing vs. declined stocks are some of them.
Total volume has been subdued since the middle of March (see chart below). The recent recovery highs have also come on the heels over decreasing breadth and a lower advance/decline ratio.
A correction of some sort could relieve some of the overbought condition and set the markets up for another push to new recovery highs.
Concern No. 3: Bearish non-confirmations
Just as a unanimous vote carries more weight than a fragmented one, mutually confirmed market moves send a stronger message than a divided market.
Last week saw the Dow Jones (NYSEArca: DIA) and S&P 500 (NYSEArca: SPY) rally to new highs. Meanwhile, higher beta indexes such as the Russell 2000 Small Cap (NYSEArca: IWM), MidCap SPDRs (NYSEArca: MDY), and Nasdaq (Nasdaq: QQQQ) failed to reach new highs.
Not only is this a bearish non-confirmation, it also shows that investors are shying away from riskier, more volatile sectors. This kind of behavior is often indicative of a rally nearing its point of exhaustion.
Another non-confirmation, according to the Dow Theory, can be found between the Dow Jones Industrial and Dow Jones Transportation Averages. Some view the Dow Theory, which has its origin in the writings of Charles Dow (founder of the Wall Street Journal and creator of the Dow Jones Industrial Average), outdated, while others consider this theory well established.
In any case, here is the logic behind the Dow Theory. When Mr. Dow published his research in the late 18th, early 19th century, the two averages were the Industrials and the Rails. Industrial companies manufactured the goods and the rails distributed them. Since both sectors were co-dependent, both sectors had to move in the same direction to validate a trend. If one went to a new high while the other one lagged, there was a bearish divergence.
Today we know the Rails as the Dow Jones Transportation Average (NYSEArca: IYT). As of today, the Transportation Average failed to confirm the Industrial’s new recovery high, therefore, creating a bearish non-confirmation.
No one-trick-pony
The Dow Theory and non-confirmations in general work in both directions. The signal can thus be bullish or bearish. Towards the end of February and early March, there was a slowing in the downtrend for the Nasdaq. Early on, the Dow and S&P 500 dropped significantly below their 2008 lows, whereas, the Nasdaq did so much later and to a smaller degree, which indicated a shift towards riskier stocks.
This, along with a composite of other indicators, lead the ETF Profit Strategy Newsletter to issue a Trend Change Alert on March 2nd, only four days before the S&P 500 bottomed on March 6th. Along with a number of ETF profit strategies for conservative, moderate, and aggressive investors, the Alert forecasted the following: “A multi-month rally, the biggest rally since the October 2007 all-time highs, should lift the indexes by some 30-40%. Tuesday's 4% spike may be an indication of the initial intensity of the rally.”
The major indexes have rallied close to 40% since, with such an intensity that hasn’t been seen since 1932. Recommended ETFs such as the Ultra Financial ProShares (NYSEArca: UYG) and Ultra S&P 500 ProShares (NYSEArca: SSO), gained between 90% and 180%. What’s next?
Based on the above mentioned (short-term) indicators, the market’s prospects for the next few days/weeks is less than rosy.
If you zoom out and look at the big picture long-term indicators, the market’s prospects become downright gloomy.
Just as a craftsman uses different tools for different jobs, market analysts (should) use different indicators for different time frames.
According to reliable long-term indicators such as P/E ratios and dividend yields, the March lows do not represent the ultimate market bottom. Why? An analysis of historic market bottoms shows that a true low has never been reached unless P/E ratios and dividend yields reach certain “trigger levels.”
To illustrate: Just as the human body is not healthy unless it runs at 98.6 degrees, the stock market is not “healthy” unless those levels have been reached.
The March and June issue of the ETF Profit Strategy Newsletter contained a detailed analysis of the P/E ratios and dividend yields, indicative of a market bottom, along with the target range for the ultimate market bottom. Even the Dow measured in the only real currency, gold (NYSEArca: GLD), confirms the conclusions drawn from an analysis of those and other indicators.
Most definitely, there is no bliss in ignorance. Quite to the contrary, Benjamin Franklin hit the nail on the head when he said: “an investment in knowledge pays always the best dividends.”
I think Investor Optimism is bad when most of the money is invested and the news is worst than expected. But investor Optimism is a good sign when a lot of cash is sitting on the sidelines and the news data is better than expected.
June 16, 2009
Author Profile
Simon Maierhofer
ETFguide
Co-Founder
Simon is the Co-Founder of ETFguide.com and worked as registered investment advisor (RIA) for 8 years. Simon holds a banking degree with honors from the prestigious German Sparkasse Bank. He grew up in Bavaria/Germany.
