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The Case for a Correction

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The market may be ready for a time-out.

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Perma-bears be damned: the stock market is making historic moves here.

Following a six-day winning streak, the S&P 500 had its best start to a year since 1987, according to the Wall Street Journal, which also notes that the Dow is up 2.3% for 2010, its strongest start in four years.

As we pointed out in a previous article, What January Says About Stocks, traders look to stock market performance in the month of January as a barometer for the rest of the year.

Sam Stovall, the chief investment strategist at Standard & Poor's Equity Research, points out that, from 1945 to the present, whenever the S&P has risen in January, it has continued to rise 85% of the time, posting an average increase of 11.6% during those years.

However, some pros caution that this stock market party is going to take a breather. So says Jon Markman of Markman Capital Insight, a full-service investment research and advisory service based in Seattle.

We caught up with Markman this morning for a brief chat, and he explained his thesis.

There's reason to believe, the adviser tells us, that we'll see the current positive phase run for another few weeks before the market rolls over into a mild, medium-term correction lasting 10 months.

"It's kind of like those cartoon moments, when Wile E. Coyote goes off a cliff, looks down, and suddenly sees how far out he is," Markman says. "Now, I don't want to stretch the cartoon analogy too far: Normally, Wile E. Coyote falls all the way to the ground. That won't happen. He will fall and land on a branch 10% below where he was."

There are many powerful crosscurrents set to intersect during the last six to nine months of 2010, Markman points out, including the mid-term election, the outside possibility of a short-term rate hike by the Federal Reserve, and bank reform that could be seen, he says, as a crusher for the financials.

But, more critically, Markman argues, there's a statistical reason to forecast weakness: Since 1950, whenever the S&P 500 has moved more than 10% over its 10-month moving average for more than seven months -- as it has now -- it next slipped sideways for at least 10 months with 10% downside potential.

Technical market indicators are also flashing overbought signals, says Markman.

Specifically, the market might be going higher, he notes, but it's supported by fewer stocks hitting new highs. On Christmas Eve, 80% of stocks were trading above their 10-day averages. Now it's 67%.

"Periods of similar breadth contraction coincided with the market tops witnessed since the March low, including most recently the tops in September and October," Markman wrote to his clients this morning.

It's important to note that this analysis doesn't mean Markman has joined the Bear den. He's simply calling for a temporary time-out, he says.

"I think we are in a cyclical bull market, even if this correction takes place," he tells Minyanville. "My research suggests that stocks have the opportunity to go back to the top of the range, which would be the 2007 highs, over the next three years."

For a different perspective, we also called up Mike O'Rourke, the Chief Market Strategist at BTIG. He doesn't see the correction coming.

"I don't see anything that we're primed to roll over," O'Rourke says. "We have a market that hit a new 52-week high yesterday. Usually, when a market does that, it trends in that direction for some time, which we've been doing all along. I haven't seen technical damage occur that would reverse that trend."

He adds, "I wouldn't want to be taking myself out of my longs here."

One contrarian metric O'Rourke watches closely is the weekly sentiment indicator published by the American Association of Individual Investors.

In a normal environment, O' Rourke says, if Bulls are less than 40%, then respondents are too pessimistic and the market is ready to rally. If Bulls exceed 70%, then respondents are too optimistic and the market is due for either a pause or correction.

The latest AAII sentiment came in at 61% bullish, moving further back down into neutral territory, the strategist emphasizes.

In terms of which sectors he now favors, O'Rourke says he's eyeing the Industrials and the Financials, which he argues are primed for a breakout after a period of consolidation.

Exchange-traded funds that offer investors exposure to these sectors include the Industrial Select SPDR (XLI), which includes holdings like Boeing (BA), General Electric (GE), Honeywell (HON), and the Financial Select Sector SPDR (XLF), with holdings including Bank of America (BAC), Goldman Sachs (GS), JP Morgan (JPM), and Morgan Stanley (MS).

O'Rourke says he's less interested in Consumer Discretionary and Materials, noting that the latter already enjoyed a big run up and are now "factoring in a stronger economic recovery than I expect."

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No positions in stocks mentioned.
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