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Rally Watch: Retracing the Gains?


Markets may consolidate, retrace before attacking longer term indicators.

A key requirement for the recent stock market gains to be more enduring and for the bear's corpse to be put to rest, is the restoration of investor confidence. A few comments regarding this issue are highlighted in this post.

As shown in Goodbye Safe Havens, Hello Risky Assets, a confidence indicator worth monitoring is the Barron's Confidence Index. This Index is calculated by dividing the average yield on high-grade bonds by the average yield on intermediate-grade bonds. The discrepancy between the yields is indicative of investor confidence. There has been a solid improvement in the ratio since its all-time low in December, showing that bond investors are growing more confident and have started opting for more speculative bonds over high-grade bonds.

Not surprisingly, a strong historical relationship exists between the Barron's Confidence Index and the S&P 500's 12-month rate of change.

Click to enlarge

The improvement in the Barron's indicator augurs well for the outlook for equities - specifically for the return of confidence - and provides further evidence that US stock markets are mapping out a base development formation.

The early January highs and 200 day-moving averages are the next important targets and a break above these levels would signal the completion of the base formation and a secular bottom (as has already been seen in leading markets such as China (FXI) and Brazil (EWZ)). (The NASDAQ is also already above its January high and 200-day line.)

Meanwhile, the speed and magnitude of the rally argue for markets to consolidate and possibly retrace some of the past 8 weeks' gains prior to launching an attack on longer-term indicators used to distinguish between primary bull and bear markets.
No positions in stocks mentioned.
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