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Stock Market Unlikely to Leap Higher Just Yet


We need to spend a few more sessions working off the overbought condition.

From Michael Lewis' Liar's Poker:
At 10:00 a.m. that day in London, Alexander telephoned . . . he wanted to know why the dollar was plunging. When the dollar moved, it was usually because some other central banker or politician somewhere had made a statement . . . but there was no such news. I told Alexander that several Arabs had sold massive holdings of gold, for which they had received dollars. They were selling those dollars for marks and thereby driving the dollar lower . . . I spent much of my working life inventing logical lies like this. Most of the time when markets move, no one has any idea why. A man who can tell a good story can make a good living as a broker. It was the job of the people like me to make up reasons, to spin a yarn. And it's amazing what people will believe. Heavy selling out of the Middle East was an old standby. Since no one ever had any clue what the Arabs were doing with their money or why, no story involving Arabs could ever be refuted. So if you didn't know why the dollar was failing, you shouted out something about the Arabs. Alexander, of course, had a keen sense of the value of my commentary. He just laughed.

So wrote Michael Lewis in his bestselling book Liar's Poker that was first published in 1989. Recall that fresh out of Princeton, and the London School of Economics, Michael Lewis landed a job at the esteemed institutional brokerage firm of Salomon Brothers. Over the ensuing three years he rose from a trainee to an institutional salesman making millions of dollars. Subsequently, he left Salomon and penned the aforementioned book, which is an insider's expose of an unprecedented era of greed and gluttony. While that era died, along with the secular bull market, I still find many of his humorous insights to be right on the mark. I remembered said quip last week when someone asked, "Who is buying stocks and preventing the stock market from correcting?!" Without even thinking I responded, "The buying is coming out of the Middle East because the rising turmoil is causing a flight to safety; and the safest place in the world is the USA." My caller then asked, "Really, why is that?" My response went like this:

In additions to being a country of laws, as well as the world's reserve currency, you are not going to wake up one morning and find out you no longer are using euros but drachmas [the previous Greek currency] that have been devalued by 50%. Indeed, the US is in the best position seen in years. To wit, there are four basic inputs that are needed to drive economic activity: 1) labor, 2) energy, 3) raw materials, and 4) financial capital. Plainly, with the current high unemployment rate we have a huge reservoir of labor. Second, the collapse in natural gas prices, and new technology in drilling, has caused our energy analysts to opine that the US is moving toward energy independence. Third, worries about a Chinese economic slowdown have pressured most raw material prices down to levels far below where they were a few years ago (exception, precious metals). As for financial capital, in this country we have record low interest rates and if rates are inflation-adjusted the effective cost of capital is zero.

"You're just a cockeyed optimist," was my caller's response. That's patently untrue, I wrote about the Dow Theory "sell signal" in September 1999, as well as the Dow Theory "buy signal" in June 2003. Then there was the Dow Theory "sell signal" in November 2007; and, I was very bullish in March of 2009. As my father used to tell me, "If you think the market is going up be bullish and if you think it's going down be bearish." Manifestly, I have been pretty bullish for more than three years with intermittent "cries" for caution along the way. As often stated, all you had to get right for the past three years has been to raise some cash in the spring and put it back to work sometime during the summer. That reoccurring strategy has worked because economic numbers began to soften every spring for the last three years. That brings on worries of another recession, which causes analysts to cut their earnings estimates followed by a decline in stock prices. When no recession shows up, they start raising their estimates and the stock market rallies. And, believe it or not, that's what is happening currently, as can be seen in the attendant Net Earnings Revisions chart from our friends at the Bespoke Organization below.

However, despite this improving earnings backdrop investors continue to shun stocks, worried about Euroquake, our dysfunctional Congress, Middles East unrest, China's slowing economy, etc. Meanwhile, many pundits have heightened those worries by talking about the weakness of the Dow Jones Transportation Average (INDEXDJX:DJT), as well as a Dow Theory "sell signal." The last time this same crowd trumpeted a Dow Theory "sell signal" was back in May when the Industrials fell below their mid-April lows confirmed by a similar move from the Trannies. At the time I was adamant that according to my work there had been NO Dow Theory "sell signal," which is the same stance I am taking now. In my opinion, the Trannies were affected last week by a downgrade of the railroad stocks from a major brokerage firm, a depression in the coal industry (less rail traffic), and the weather (Hurricane Isaac). Regrettably, it will be a few months before we see if that is the correct "call."

Certainly many of the sectors, as well as indices, think that is the correct "call" because the biotechnology, consumer discretionary, consumer staples, and health-care sectors have traded to new all-time highs. Ditto, the S&P Equal Weighted Index (INDEXNYSEGIS:SPXEW), the S&P 400 Mid Cap Index (INDEXSP:SP400), the S&P 600 Small Cap Index (INDEXSP:SP600), and the Value Line (VALU) Arithmetic Index have traded to new all-time highs. If past is prelude it should not be too long before the S&P 500 (INDEXSP:.INX) does the same thing. Of course this differs with the election year chart I have been using this year, which telegraphed a peak for the SPX at the beginning of September follow by a pullback into mid/late-October and then a rally to higher highs. And, it looked like we were going to get a continuation of that election year trading pattern until the Federal Reserve announced QEternity. On that announcement the 98% correlation with the typical election year trading pattern completely fell apart as the INDU vaulted 206 points. The Dow Delight, however, left ALL of the macro sectors I monitor severely overbought; as well, the NYSE McClellan Oscillator was about as overbought as it ever gets.

Accordingly, in last Monday's missive I wrote:

An overbought condition can be resolved in one of two ways. First, the SPX can pause and move sideways while the overbought condition is remedied. Second, the SPX can pull back to what had previously been an overhead resistance level, but now becomes a support zone. In the current case that would entail a pullback to 1400 – 1422 for the SPX. Importantly, when the stock market generates an overbought condition of last week's magnitude it suggests there is more strength coming in the future after the overbought condition is rectified. Indeed, uptrends typically do not end on really high overbought readings from the NYSE McClellan Oscillator. So, while two weeks ago I thought we were reaching for a short-term "trading top," I believe that following some kind of pullback, or sideways movement, the major market indices will go higher.

On Tuesday I modified the strategy by noting that given Monday's trading pattern we were probably going to get a sideways correction; and that's exactly what we got last week, which brings us to this week.

The call for this week: Speaking to the divergence of the Industrials and the Transports, Bespoke had this to say:

Over the last six months, the Dow (INDEXDJX:.DJI) is up 3.47%, while the Transports are down 7.90%. While wide, the 6-month spread in performance between the two is not out of the ordinary, as shown in the chart. At the same time, peaks and troughs in the performance spread have not really been bullish or bearish for the future direction of the overall market either. While the spread could widen more, it's likely that we'll see a reversal in the relative underperformance of the Transports in the near future, but that doesn't mean the Dow is doomed (see chart).

Obviously I agree, yet it still does not feel like the stock market is ready to leap higher until we spend a few more sessions working off the overbought condition.
No positions in stocks mentioned.
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