The Rally is Here, but...

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


The Rally Is Here, But…

Last week, I spend some time with the folks at Yahoo! in New York taping two segments for their Yahoo! Finance show Breakout. What a great time! The first segment pretty much spells out my view of the stock market: Bull Market or Bust.

If that segment wasn't controversial enough, the second segment, Bye Bye Euro, is about my long-term view that the Euro currency will cease to exist in the next 10 to 20 years. As I have mentioned before, it's all about the "haves and the have nots". While North Carolina may want to help save South Dakota, it's very difficult for the country of Germany to want to bailout Ireland or Spain or Portugal. And the countries in need want help on their terms, not austerity rammed down their throats.

The stock market certainly has done its best to confound the masses, as it usually does. The decline from the April peak pushed the envelope of what I call the normal, routine and healthy 4-8% pullback, but so far, that's exactly what it has been, 8% from high to low. I certainly did not think it would get to 8% and perhaps I have been a bit too complacent about it. But as I have done my whole career, I follow our models and the evidence at hand.

Over the past few weeks, stocks haven't done much, but the headlines continue to make it feel like the economy and markets are falling off the cliff. I think it is all part of a more complex bottoming process, which is usually required the deeper a decline goes. Between Greece and jobs and the debt ceiling and housing and QEII ending, it's tough to read the news. I would argue that if things are really as bad as the news suggests, stocks should be down a whole lot more than 8%. Judging from the action this week, that process appears to have ended with a rally beginning.

As most of you know, we use technical and quantitative inputs in our work as opposed to fundamental inputs. At the lows of the past few weeks, the stock market is now more oversold than it has been since the bull market began in 2009, even more so than during last spring's 17% correction.

Some of you may argue that we are no longer in a bull market and that's why the oversold readings don't matter as much. Given that the number of stocks advancing and declining (A/D line) hit an all time high in April along with junk bonds, that would be highly unusual. Even if that's the case, which I am not willing to concede on June 30, there is still supposed to be at least a failing rally.

My premise has been that from this decline, we will learn what kind of market lies ahead for the second half of 2011 based on the quality of the next rally. Which indices and sectors are leading and lagging. Is there broad participation? How do junk bonds and small caps, barometers of liquidity, behave?

Over the past few weeks, we have a whole host of indicators pointing to a bottom. The number of stocks advancing and declining on a daily basis is very washed out, too much selling too quickly. Most of the derivative indicators, like the McClellan Oscillator, are saying the same thing.

Volatility has increased dramatically from very low levels. Usually, it pauses or reverses after such a rise. According to AMG, investors have drained incredibly large amounts of money from equity mutual funds recently. At the same time, option traders on a variety of exchanges are becoming very defensive. Small option traders, usually mom & pop traders, have gone from exuberant to despondent in just a few weeks.

On an intra-day basis, we are seeing rolling large blocks of liquidation hitting extreme levels where rallies often begin. On the flip side, buying by corporate insiders has increased substantially and they are usually not wrong for very long. Add it all together and you get the recipe for a good stock market rally.

After a 6% or 8% pullback with the slew of indicators pointing to a low, we should be seeing constructive price action with at least some upside follow through. Until last Thursday, that was sorely missing. We now have a number of positive behavioral days with some follow through confirmation as you can see below.

SO much attention has been paid to the level of 1250 on the S&P 500 (the March tsunami low), I was hoping for a quick plunge through that level to shake out the final bulls.  Twice, price came closer, but no cigar.  In a perfect world, price dives through 1250 for a day or so and causes more selling that makes headlines, only to see the bulls step up to reverse the trend and start a powerful that rally to trap the bears as the I tried to depict in the next chart.

On the surface, I believe a break of 1250 is more constructive for a longer and more meaningful rally than if the rally has already begun. A rally from here will leave unanswered questions and keep a scenario open for a decline below 1250 sometime during the third quarter.

FYI, I will be on CNBC’s Squawk on the Street on July 5 at 9:35 a.m.

Have a very safe and enjoyable holiday weekend!

Feel free to email me with any questions or comments at Paul@investfortomorrow.com.


Until next time…

Paul Schatz
Heritage Capital LLC

http://www.investfortomorrow.com/
http://RetirementPlanningConnecticut.com/

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