Common sense thinking tells us that what goes up must come down. But how do you quantify “up?” The market has gone up further than many expected and defied common sense thinking. Can it continue to do so?

Today may be an indication of what the market has in store for us, as it responds to financials' earnings.  Big players, such as Bank of America and Morgan Stanley, revealed their bottom line and missed the Street's estimate by a long shot.  Can this be attributed to Tarp repayment only, or is something more culpable behind the scenes?

In addition, one must find it peculiar that the market continued to rally, even though top on-line brokerage firms, such as Scwab and TDAmeritrade, confirmed large drops in profit due to lower trading volume and near zero interest rates. 

Up until last Friday (1-15-10), the price chart of the major indexes ala Dow Jones (DJI: ^DJI), S&P (SNP: ^GSPC) and Nasdaq (Nasdaq: ^IXIC) looked fairly solid. It wasn’t healthy, but the up-trend had remained intact throughout November, December and early January.

A closer look at the chart pattern (see chart below) since the March lows shows that prices have adhered strictly to the trend channel established early on. Starting in late November, the upper line of the trend channel lost the gravitational pull that kept stocks moving higher for months.

At that time, the up and down gyrations of the S&P 500 (NYSEArca: SPY) became smaller and smaller.

Madoff vs the S&P 500

Looking at the chart brings to mind another saying; if it looks too good to be true, it probably is too good to be true. When Bernie Madoff’s investment scheme blew up and embarrassed many high society investors, didn’t we all wonder how anyone could have fallen for this scheme, it was simply too good to be true, right?

The straight green line on the chart represents a hypothetical investment in Bernie Madoff’s “funds” before investors caught on and started demanding their money back.

Aside from a small hiccup in July, the direction of the market has been up, and up only. Until last week, the trend remained intact, so far so good. To the casual observer, the market’s health continues to look solid. But as so often in life, the closer you look the more cracks that show up.

The chart identifies some of the cracks – lack of conviction. The red columns at the bottom represent total NYSE trading volume. Aside from one spike caused by quadruple witching in late December, volume has been declining since November.

Mythbuster – a new bull market has started

It is generally believed that volume always dries up around the holidays. That is correct, but consider the following: Average daily trading volume since January 2003 has been 1,595 billion shares. The average trading volume since the beginning of the rally in March has been 1,351 billion. New bull markets rise on elevated, not decreasing, volume.

Since December 1, 2009, volume has been only 1,151 billion. January usually sees traders return to Wall Street. Not in 2010. The average daily trading volume for the first part of January was a mere 1,086 billion, a 32% decline.

There was an uptick in volume on Friday, 1-15-2010, when 1,408 shares traded on the NYSE. Unfortunately, stocks dropped over 1% that day. But wait there is more. A number of nuances make Friday’s decline notable. Not only was the decline accompanied by the highest volume thus far in January, it was also broad based with overall breadth being decisively negative.

Good earnings – lower prices, how come?

Furthermore, the night before (Thursday), Intel released blockbuster earnings, which sent the stock higher in after-market trading. Despite Intel’s strength, the Nasdaq (Nasdaq: QQQQ) and Technology Select Sector SPDRs (NYSEArca: XLK) sold off more than the Dow and S&P 500.

Just before Intel’s announcement, the Dow and S&P rallied to new recovery highs. Those recovery highs were unconfirmed by the Dow Jones Transportation Index (NYSEArca: IYT), Nasdaq, Dow Jones Utilities Sector (NYSEArca: XLU), and Dow Jones Total Market Index (NYSEArca: TMW). Could this be a case of “buy the rumor and sell the news?”

Other economically sensitive sectors, such as financials (NYSEArca: XLF) and consumer discretionary (NYSEArca: XLY), started their decline already a week earlier.

Friday’s performance in financials mirrored the performance in technology. JP Morgan, the first major bank to report earnings, beat Wall Street’s consensus estimate by 13 cents a share, yet the financial sector sold off. Why? Nobody knows for sure, but here are a few clues.

Reuters reports that the bank’s large mortgage and credit card businesses have seen rising credit costs, offset only by record investment banking revenue. Losses even on prime mortgages almost tripled compared to 2008.

Yes, mortgage/credit card losses were three times lower in 2008, the epicenter of the mortgage crisis, than in 2009, the year stocks rallied 65%. JP Morgan CEO Jamie Dimon stated that, “We don’t know when the recovery is.” This blunt honesty is as refreshing as it is concerning. One thing we’ve learned is that bank CEO’s tend to be more optimistic than the situation warrants.

Painful but true

Short-term memory loss is a condition that befalls us all. When it comes to personal relationships, it might actually be beneficial to forget the last time somebody wronged you. When it comes to investing, it’s different.

Less than a year ago, financial and banking stocks (NYSEArca: KBE) traded more than 80% below their 2007 high watermark. There was a reason for that. In 2008, financial CEO’s (including Fannie Mae, Freddie Mac, AIG, Bear Stearns and Lehman) were cheerleading their own companies. In September 2008, the ETF Profit Strategy Newsletter considered the financial sector a “downward spiral with no stop-loss provision.”

This proved true. In March, however, it was time to switch gears. Via the March 2nd Trend Change Alert, the ETF Profit Strategy Newsletter recommended to buy financial and leveraged financial ETFs such as the Ultra Financial ProShares (NYSEArca: UYG). UYG gained over 300% since.

One of the keys to investing is to use common sense. It makes sense, therefore, to examine banks’ health, especially since the banking sector has gained nearly 150% in ten months.

As part of the Public Private Investment Program (PPIP) and bank stress test, the government asked financial institutions to shore up their balance sheets. This was in May 2009. Banks did so by taking advantage of the government endorsed trick that allowed financial conglomerates to artificially inflate their balance sheets without adding a single cent (full report available in the June 2009 issue of the ETF Profit Strategy Newsletter).

Because stocks rallied, banks were able to create revenue through their investment banking operations. Due to rising prices, investment profits jumped roughly ten-fold from Q4 2008 to Q4 2009. But, what happens when stocks don’t rally? More importantly, will stocks continue to rally?

An important juncture

In the onset of the article we examined the waning fundamentals supporting this rally. A look at yet another layer of research will show why stocks are slowing down now.

Looking at the 2000-day moving average (MA) allows investors to scan the market for potentially important turning points. As it turns out, the 2000-day MA for the S&P 500 sliced through 1,156 last week. Thus far, the S&P climbed to 1,150 and reversed sharply. The 2000-day MA, like its smaller cousin, the 200-day MA, might prove to be stiff, even formidable resistance for the S&P.

Another point of resistance is the 52% retracement level. There is no specific significance to the number 52 aside from the fact that the Dow Jones retraced 52% of its previously lost points when it recorded its 1930 high. Following this counter trend rally, often dubbed the biggest sucker rally of all time, the Dow declined another 70%+.

Right before the 1930 market top, investors’ felt confident about stocks future as they do today. The March 25, 1930 issue of the New York Times reported the following: “Wall Street was in a cheerful frame of mind as a result of numerous vague reports of improvement in business and industry.”

No two words capture the essence of the recent rally better than cheerful and vague.

If you’d like to put a number on “cheerful,” you will find that investor sentiment today has reached the same levels of optimism as in late 2007 (Investors Intelligence survey of bullish advisors) and April 2000 (American Association of Individual Investors cash allocation). We all know what happened both times.

What goes up must come down. If you had to academically quantify up, S&P 500 might be the number that marks the end of this rally.

The brand new issue of the ETF Profit Strategy Newsletter includes a detailed short, mid and long-term forecast for all major asset classes, along with target and safety levels for the U.S. stock market.