Storms Brewing for the Stock Market

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

With the month of September and third quarter of 2009 just ending, it’s a good time to reflect on the financial markets and take stock of where we are and where we may be headed. As individual investors, it’s important to stay on top of your portfolios and I usually recommend doing this quarterly with more emphasis placed on the annual review. The vast majority of investors do not want or enjoy valuing their holdings daily, weekly or monthly, and frankly, that’s why you hire advisors. It’s our job to get you from day to day, week to week and month to month.

Since the March 6 bottom in the stock market, we’ve seen a truly historic rally across the board. It’s certainly been “the rising tide lifting all ships”. Unlike previous attempts to rally during the bear market, selling into strength has not been rewarded as the pullbacks have been very brief and shallow. That in itself was an indication that the character of the stock market was changing in April and May.

By the time June came, a very important hurdle was overcome. In most bear markets, rallies do not last more than 11 weeks. Once we got past that point, it was further confirmation that the overall tone of the market had changed from down to at least neutral, if not up. And similar to 2003 when we last emerged from a bear market, the early June peak led to some much needed digestion or consolidation over the next month or so.

Since the last decent low in July, we’ve seen the stock market embark on another nearly vertical run to its mid September high. Similar to what we saw coming out of the March bottom, anyone who sold into the rally was not rewarded and forced to either chase the rally higher or sit uncomfortably with cash during a rising market. As someone who made what I felt were good sales at the time and held some cash, I would much rather wish I had more skin in the game than get stuck during a collapse with too much on the line!

Fast forward to today and for the first time since the rally began in earnest, there are some storm clouds brewing on the horizon. To begin with, several sentiment surveys have come full circle, now showing far too many bulls versus the bottom in March when we saw almost all bears. Similarly, small-time option traders, the ones I commonly refer to as mom and pop, have been exhibiting very bullish tendencies of late.

None of the behavior above can be construed as positive for the market since it usually occurs near market peaks, not valleys. Think of it this way, when everyone is sure of a particular outcome, how often do we see the opposite happen. It’s worse in the financial markets. If the masses are very positive, wouldn’t that mean they already invested and have little cash left to propel things higher? If everyone bought a blue Toyota this year because it got 1000 miles to the gallon and all service was free, who would be left to buy next year?

Besides sentiment not being favorable right now, the stock market has lost “the rising tide lifting all ships”. Typically, as rallies get long in the tooth, we see fewer and fewer sectors keeping pace and leading the charge higher. And those that turned early, say in January or February, will likely turn early before the rest of the market begins to correct. That’s certainly the case now with the Chinese market underperforming. Here in the U.S., the housing stocks, transportation, materials, energy, agriculture, metals and mining have all begun to lag the indices, signaling a “tired’ stock market in need of rest. Should the various technology groups begin to follow suit, it won’t be long before a widespread correction sets in.

Finally, the catalyst for the summer rally was based on earnings that were better than expectations and much “less worse”. With earnings season officially starting on the 7th at 4:00 pm with Alcoa, the likelihood of a repeat performance is remote. At best, history says we can expect a neutral period, but most of the time, following such strength, the next period is weak.

Add it all together and I come up with the best opportunity for a correction since the bull market began in March. If I had a crystal ball, it would say that stocks are in the topping process and should be completed by the 16th. If the correction appears, it should be the most significant since March, taking 8-15% off the major indices. In Dow Jones Industrial numbers, that’s a decline of 800-1500 points that should wrap up sometime in late October to mid November.

For those curious as to why I have such a big range in the numbers, it’s because it’s tough to pinpoint the downside target until we begin to see some weakness and how investors behave. If people use the 8% decline to buy and become even more positive, that opens the window for another 8% lower to clean out the weak-handed holders and get folks to worry more that their recent purchases will be losers. If, on the other hand, after an 8% correction, the media is talking about the end of the bull market and much lower prices to come, chances are the correction is over already.

The good news is that if we see a correction in stocks, it should only serve as a much needed and healthy pause to refresh, with higher prices to come later this year and in early 2010. If by some chance, we get to Halloween without any weakness, the window of opportunity for a significant correction will likely close until the New Year.