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Sorting Through the Confusion



I have been writing a great deal about rotation lately instead of the potential in either direction of the major market indices. From a broader market perspective, I can make a very positive or negative case right now, which means I should focus less on confusing myself (and therefore anyone listening to me) and more on rotation. Let me show you what I mean.

The Positive Case

The price action suggests that a significant breakout may have just taken place and that the major equity indices are going a lot higher. I am careful to use "may have" because I was taught that in order for a breakout to be valid, you need the price to be above the breakout for two days or two periods (two days in a daily chart, two weeks in weekly chart, etc.). So far that hasn't happened.

In theory, when an Index or stock is in a definable trading range and then breaks out, you take the spread of the range and add that number to the level of the breakout. So in the case of the S&P 500 (SPX); the definable range since last July is roughly 780-950. The spread using my numbers (again, this is an art and not a science so other people's numbers could be a little different) is roughly 170 points. If you add that number to the breakout price of 950, you get a target of 1120 for the S&P 500 over coming months.


The significant decline in interest rates makes fixed income vehicles much less attractive. Prior moves toward 3.5% on the 10-year government bond have generated increased interest in stocks over the past year. The yield is obviously below that, and stocks appear to be breaking out. As money comes out of bonds, it is even more likely to find its way to stocks.


The Negative Case

The sentiment measures seem to have reached pretty extreme levels. For example, according to Investors Intelligence, the percentage of bearish investment advisors is at the lowest level since February 1992. In other words, are were fewer bears now than during the heat of the equity market bubble. The lowest reading during the bubble time (late 1990s) was 25% bears in July 1999. Pretty amazing (thanks to Jason Goepfert at Readings like this suggest any breakout won't be sustainable for more than a brief period of time.

Mutual fund cash levels as a percentage of assets were at 4.3% in February and 4.8% in March. Historically, those are very low readings, which suggests that unless there is another bubble-like shift by individuals into the equity funds, any near-term gains should be unsustainable. The reality is that it is hard to invest evaporated money. And employment statistics show consumers are hoping to keep their jobs and are not seeing increased income that could find its way back into the market that just hurt them.

The market's level of overbought suggests that the best-case scenario, looking ahead more than a few weeks, could be a sideways consolidation pattern.


In sum, conflicting evidence out there causes confusion. When you combine the worries over low levels of cash and the less favorable risk/reward for stocks -- given the sharp gains, hopes over the simulative effect of lower interest rates and access to the capital markets by corporations -- you get a recipe for less broad market bets and more sector rotation trades. The way I see it, either stronger or weaker markets should cause the Consumer Staples to outperform.

No positions in stocks mentioned.
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