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U.S. Stocks Are Hanging By a Thread – But It’s a Tough Thread

Stock-Markets / Stocks Bull Market Jun 17, 2010 - 05:28 AM GMT

By: Money_Morning


Best Financial Markets Analysis ArticleJon D. Markman writes: If you ask me, the current bull market in U.S. stocks is hanging by a thread.

In fact, a decline that takes the Standard & Poor's 500 Index down below the 1,040 level - roughly 7% below where it closed yesterday (Wednesday) - would probably murder the bull-market case for stocks.

But until that decline actually occurs, don't rule the bulls out for the count.

That "thread" may be tougher than you think.

Broadly speaking, U.S. stocks have been in a bull-market cycle since early May 2009, when they rebounded sharply from a bear-market bottom. A sharp sell-off that started in late April and lasted into early June gave the S&P 500 a 14% haircut.

Stocks have rebounded about 6% from that early-June nadir, but remain about 8% below their late-April highs. And they've entered a highly volatile whipsaw phase that's badly spooked investors, especially given the debt-problems in Europe and the contradictory economic reports that seem to appear about the U.S. market almost daily.

To get a good gauge of just where we are in the current stock-market cycle, we're going to take a look at three market-cycle indicators, each of which - historically - has a pretty good record of telling investors what's to come for U.S. stocks. Those three indicators are:

•The Lowry Research Corp."buying power" and "selling pressure" indexes.
•The Smart Money/Dumb Money Confidence sentiment indicators published by Jason Goepfert of Sundial Capital Research.
•And the Arms Index, a technical-analysis indicator that provides a good view of short-term trading conditions.
Let's take a look at each indicator, and see what it has to say.

Lowry Research: The Bull Still Rules
According to Lowry Research analysts, if you look back over the past eight decades, every major market top has been preceded by a sustained period of rising supply and falling demand as profit-taking becomes increasingly aggressive. That's what makes the "buying power" and "selling pressure" indexes so useful.

The folks at Lowry are sticking to their belief that the recent decline in U.S. stocks is a correction within a primary uptrend. On Friday, Lowry President Paul F. Desmond wrote: "Our founder, L.M. Lowry, used to say that the real purpose of the stock market is to confound the largest number of people possible. In that regard, it has been doing a remarkable job. In comparing the market decline from the April rally high to similar situations throughout our 77-year history, we have concluded the recent weakness has been part of a correction within a primary uptrend, rather than the start of an extended bear market."

According to Desmond, the length of the recent correction - and its intensity - have put investors on edge, and kept them there.

The decline in U.S. stock prices from April highs beg an with Lowry Research's short-term indicators already weakening from "overbought" levels, Desmond said. It then took until late May for all of the short-term indicators to finally reach deeply "oversold" levels.

Since that time, Desmond said there have been two "90% upside days" [NYSE upside volume/(NYSE upside volume + NYSE downside volume) is greater than 90%] - on May 27 and June 2 - with each offering some hope that the selling had been exhausted and that buyers were rushing in to snap up the bargains.

In each case, however, that hope was dashed by the quick re-appearance of "90% downside days" - which took place on June 1 and June 4. These days of renewed intense selling suggest that the 90% upside days were due mostly to premature short-covering from traders, with virtually no follow-through from accumulators.

"As long as this condition exists, the probabilities will continue to point toward lower prices," Desmond concluded.

In an interesting - but potentially telling - aside, Desmond says "it is conceivable" that some fairly recent developments have affected the U.S. stock market. Indeed, Desmond says that the U.S. Securities and Exchange Commission's elimination of the so-called "uptick rule" in July 2007 - combined with the unrestrained explosion of computer-controlled, "high-frequency trading" - has led to an unprecedented rash of 90% down days and created corrections more intense and longer lasting than in the past.

In response, Desmond's team has created a new "safety control" to help clients protect portfolios in the event that automated trading has created a new environment of intense selling.

The new method would push Lowry to observe that a new bear cycle has begun if "buying power" falls 20% from its high and "selling pressure" rises 19% from its low.

So far, neither of these new triggers have been tripped. In fact, a "positive divergence" has emerged of a type that often appears before renewed U.S. stock market rally attempts.

Current Assessment/Current Outlook for Stocks: The decline that has left U.S. stock prices below their late-April highs is a correction within a primary uptrend. The overall outlook is reasonably positive.

Sundial Capital: Shadows Grow Over U.S. Stocks
That brings us next to the Smart Money/Dumb Money Confidence sentiment indexes published by Jason Goepfert of Sundial Capital Research. Frankly, I don't think the Smart/Dumb indexes show us very much: Four times during 2008 the spread reached low extremes (a bullish indicator); but each would have led to sizeable losses even if the stocks were held until they could be sold at the highs reached in April 2010.

The current low in the spread is about at the same level as March 2009, but it would not have been considered an extreme in 2008. Furthermore, it looks like the "Smart Money" got very bullish in the late summer of 2007 - just before the market topped. While this kind of sentiment chart is not great for precision timing, it does combine a lot of useful information in one indicator.

However, please let me note that Goepfert has provided two new sentiment studies that are interesting and important enough for you to know about. One is modestly positive and the other very negative .

In the first study, Goepfert pointed out that the May market crash badly scared the private investors who populate the American Association of Individual Investors (AAII), as a survey of members showed a stunning 15% drop in allocations to stocks at the end of May from the end of April. That was the third-largest one-month drop in the survey's 23-year history.

Goepfert calculated how the market did in the one-, two- and three-month periods after all allocation drops of 10% or more, of which there were 14 dating back to 1988. The returns from the end of the drop month (in this case, from May 28 forward) were +1.1%, +1.6% and +1.1%, respectively.

That's not so hot, really, as a 1.1% gain in three months amid a lot of volatility would be aggravating. There was, however, quite a lot of variability, ranging from a (-9.4%) three-month return after similar events on Aug. 31, 2007 and Oct. 31, 2008, to roughly +10% three-month returns after Sept. 2, 1988 and Sept. 3, 2004.

In the second study, Goepfert looked at how the market tended to do following the price pattern seen last week, in which the S&P 500 hits a three-month low, then records two consecutive "up" days for the first time in a month. Investors often take that to mean that a decline is over, but the data doesn't support that. The sequence has occurred 26 times since 1928, and average returns over the next day, week, two weeks, one month, three months and six months are all negative: (-0.3%), (-1.8%), (-1.9%), (-1.9%) and (-1.1%).

This scenario occurred three times in 1931 - on April 20, Oct. 16 and Dec. 19 - with very negative six-month results of (-23%) to (-35%). The two most-recent examples occurred on Oct. 31, 2008, resulting in a (-6.7%) loss in six months, and May 1, 2002, resulting in a (-18%) loss in six months. Here's what's especially troublesome: The results ominously cluster up in 1930-1932, 1970-1978, and 2001-2002, all very bearish periods - not just corrections.

Goepfert calls these results "bearish - pure and simple." Furthermore, he notes that the persistence of the declines leading to new multi-month lows usually occurs soon after the two consecutive "up" days.

As a "weight-of-the-evidence kind of guy" - and based on the totality of his current sentiment work - Goepfert says he's inclined to look for higher prices in the coming weeks, but would not stick around if recent support at the February lows fails to hold.

Incidentally, I share this viewpoint, which is why I have taken up so much space explaining it.

Current Assessment/Current Outlook for Stocks: Continue to look for higher stock prices in the weeks to come, but head for the exits if the February lows fail to hold.

The Arms Index: Sellers Due For a Breather
The Arms Index is an indicator that is used to show overbought and oversold extremes (through the use of a ratio of advancers vs. decliners divided by advance/decline volume). On June 4, the index hit a level that has only been seen seven times since 1940. The market's level at the close that day was higher than all but one day of the 2008-2009 bear market, showing that investors were just piling out of stocks that day willy-nilly.

The Arms Index indicator has a long history of signaling important local bottoms. It's not perfect, but it does at least tell us that even if the market is ultimately destined to head lower, the market is now at a point where even the most-determined sellers are likely to pause for a breather.

Current Assessment/Current Outlook for Stocks: If sellers are willing to continue to press their luck, they could break the market. It's a low-probability event - but it is possible. However, if stock prices are destined for a decline, the market is now at a point where even the most-determined sellers are likely to pause for a breather.

The Overall Outlook: It Ain't Over 'til It's Over - Literally
So where does this leave us right now? Here's what I see.

I'm looking for higher U.S. stock prices in the weeks to come. But it's clear that the current bull-market cycle is hanging by a thread. An S&P 500 decline below the 1,040 level could be enough to snuff out the bull-market case for U.S. stocks. For stocks to drop that far, the S&P index would have to decline about 7% from yesterday's close of 1,114.61.

If sellers are willing to continue to press their luck, they could break the market. It's a low-probability event - but it is possible.

That being said, you can't actually rule the bulls out for the count until the afore-mentioned decline actually occurs. Stock-market bulls are well-known for pulling a rabbit of a hat - and doing so in the dark, while their eyes are closed. That's something that happened at least five times during the 2003-2007 U.S. stock market advance; it occurred four times in the zingy year of 1999 alone.

We'll be watching these key indicators - and others - very closely. Whenever there's something new to report, or a change in our viewpoint, rest assured that we'll report back to you with all the details you'll need.

[Editor's Note: Money Morning Contributing Writer Jon D. Markman has a unique view of both the world economy and the global financial markets. With uncertainty the watchword and volatility the norm in today's markets, low-risk/high-profit investments will be tougher than ever to find.

It will take a seasoned guide to uncover those opportunities.

Markman is that guide.

In the face of what's been the toughest market for investors since the Great Depression, it's time to sweep away the uncertainty and eradicate the worry. That's why investors subscribe to Markman's Strategic Advantage newsletter every week: He can see opportunity when other investors are blinded by worry.

Subscribe to Strategic Advantage and hire Markm anto be your guide. For more information, please click here.]


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