Friday, October 16, 2009

The Dow at 10,000: Is It Time to Celebrate?

(Editor's Note: Paul Schatz, President of Heritage Capital, LLC, in Woodbridge, will be contributing to Fi$callyFit every Friday. Read his biography here)

A few weeks ago, I wrote an article here entitled “Storms Brewing for the Stock Market”. The third quarter had just ended and that is always a good time for a quick review of your holdings and investment strategies. With the major stock market indices rallying from the March bottom, almost unabated, I opined that some trouble could be brewing around the corner this month.

To take it a step further and really pigeon hole myself, my analysis concluded that the small pullback that began in late September would soon wrap up and lead to a final, last gasp rally that peaked this week. Thankfully, the market decided to cooperate and the anticipated strength into this week arrived on schedule, thanks to Intel and JP Morgan beating earnings estimates.

So, are storm clouds still brewing or is Dow 10,000 cause to celebrate the all-clear signal? Let’s first analyze the original reasons that caused me concern for the market after this week. First, the two weeks before each earnings season officially begins with Alcoa, stocks tend to see some weakness as companies have a habit of pre-announcing bad news. Once that period ended and Alcoa beat Wall Street estimates, the market breathed a sigh of relief, more money flooded in to stocks and investors became even more positive.

The problem with people becoming very positive or negative (sentiment) on an asset class like stocks is that it typically comes at the end of a move. Right now, sentiment is very bullish on stocks and that’s not been a good sign looking ahead historically. Similarly, small-time traders who speculate in the options market are usually wrong and they’ve been positioning for further strength in stocks, another problem.

Today is monthly option expiration, the single day each month when options expire and no longer trade for that series. Historically, the stock market tends to follow the current trend during the week and reverse the following week. Since the market has been going up since last month, that means this week is generally a positive one, but next week should see some give back.

As I mentioned earlier, Intel and JP Morgan exploded higher after beating Wall Street’s earnings estimates. On the surface, that sounds like a reason to celebrate and expect more gains, but history shows that outsized moves like we saw based on earnings or a major economic release can lead to the end of a rally more than a continuation. Additionally, last earnings season was a blockbuster in terms of stock market performance and that’s rarely repeated back to back. The best the market can anticipate is neutral to slightly higher this quarter.

Total market volume (the number of shares traded each day on the New York Stock Exchange and NASDAQ) which is considered to be the horsepower of the market, has not exploded higher with price. Like a rocket ship running out of fuel before clearing the atmosphere, this is a warning sign.

Mutual funds typically end their fiscal years on October 31. When prices don’t behave as anticipated, mutual fund managers can flood the market with orders in both directions. I rate this more of a wildcard than negative sign.

Before you stop reading and start thinking that the bear market is about to jump out, grab and maul you, I don’t think that’s in the cards. When markets trend strongly in one direction, windows of opportunity periodically arrive to signal a reversal. During the bear market of 2007-2009, these windows arrived no less than seven times before finally taking hold and reversing to a bull market. The other times, we just saw corrective rallies within an ongoing major downtrend.
This month, a window of opportunity MAY be opening for a corrective decline to help the market wash away some of the excess. It would be healthy, welcomed and lead to another rally with higher prices into 2010. My initial read was that IF a correction took hold, it should be in the 8-15% range and wrap up sometime in late October to mid-November.

Before finishing up, as I always do when I have a forecast, I like to take the other side and figure out if and how I will be wrong. After 21 years in the business, I’ve learned the hard way that getting too attached to a certain market roadmap can be hazardous to your portfolio and business. The first that I am wrong will be if we finish the month at new highs with no sign of let up. This week’s rally has been a bit more powerful than I thought it would and maybe that’s the first hint that a full fledged 10%+ correction may not be in the cards. But that will be easy to analyze once we see how the first bout of weakness looks.

The number of sectors leading the market higher has only slightly diminished and that usually does not lead to a significant decline in stocks right away. And finally, the stock market has been closely following the pattern from 2003 when we last emerged from a bear market. After a bottom in March, stocks generally trended higher right into January 2004 with only an early summer pullback in its way. At some point this and all correlations diverge, but until it does, it pays to follow it.

So there you have it. Evidence has mounted that a window of opportunity is about to open for the largest decline since the bull market began in March. I’ll have more to add if and when we see the initial round of weakness, possibly next week.

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