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Saturday, August 29, 2009

So why shouldn't stocks continue to rise?

It's been a month since I last posted charts of the statistics we track at Alert HQ. Are there any new insights we can gather from a review of these charts?

In the last month, the major averages have doggedly managed to climb a few percent, while all the while bears have been saying stocks are over-priced and heading for a fall.

Fundamentally, economic reports have been rather benign though stubbornly high levels of unemployment remain a worrisome factor.

Earnings season continued through the month and is pretty much over now. Many stocks beat lowered expectations and a good number also provided decent forward guidance.

So why shouldn't stocks continue to rise?

The two main weapons in the bears arsenal are:
  • Stocks have outrun their fundamentals. Both trailing and forward PEs are way too high compared to historical norms
  • Stocks are over-bought. The rally from the March lows has been virtually uninterrupted. A pullback is due.
My answer to the bears would be: "Yeah, maybe."

Here's why:
  • Formulating forward PE ratios is notoriously difficult. Bears could just as easily be wrong as right.
  • If you give export demand due to recovering emerging economies greater weight in your analysis, perhaps forward PEs may not be that high after all.
  • Economic indicators are slowly (sometimes very slowly) improving. Virtually none are appreciably worse than they were a few months ago.
  • Sure, stocks appear to be over-bought. But given that we have emerged from a generational bear market low and the economy is clearly on more solid footing, should it be any surprise that the market is rising steadily and could continue to rise? Right now, volume is low and there are not many signs of the kind of widespread speculation that marks a top (though there is some evidence of it happening among the financials).
  • Interest rates will not go up anytime soon.
  • We will of course have minor pullbacks along the way but the return to the March lows seems to become less likely every day. So why not be bullish?
Well, those are my opinions. So where are the markets today and where might they be going? We look for clues in some of the charts that follow.

The view from Alert HQ --

Charts of some of the statistics we track at Alert HQ are presented below:

SPY vs the market, Moving Average Analysis, 08-28-2009
The above chart, illustrating our moving average analysis, is at a bullish level but is indicating caution. Note that the number of stocks above their 50-day MA is slightly below the number of stocks whose 20-DMA is over their 50-DMA. This does indicate that, in the short term, this rally could be running out of steam and pullback could occur in perhaps a couple of weeks. This chart is an example of the over-bought thesis where roughly 80% of stocks are above their 50-DMA and, to many market observers, that seems like too many.

In a bull market, however, this chart takes on the characteristics of an oscillator. In other words, with each rally, the levels will reach where we are today. Each pullback will reduce the levels somewhat and then each subsequent rally will push the levels up again. I suspect that the 80% to 85% range can be considered a maximum bullish level and that's about where we are now.

The next chart provides our trending analysis. It looks at the number of stocks in strong up-trends or down-trends based on Aroon analysis.

SPY vs the market, Trend-Analysis, 08-28-2009
Here we see the number of stocks in down-trends sitting at a pretty low level while the number of stocks in up-trends hit a peak, then weakened and is now in the middle range.

According to this chart, stocks are not particularly frothy or over-bought. Strong up-trends have been broken as stocks have moved sideways over the last week. Could the number of stocks in up-trends surge higher? Well, there is plenty of room for that to happen since we are not at an extreme level.

The interesting anomaly in this chart is that while the number of stocks in up-trends has dipped there has been no corresponding rise in the number of stocks in down-trends. Stocks are essentially treading water. I would interpret that to mean there is an underlying strength in this market.

Conclusion --

The two charts presented today do not paint a picture of a severely over-bought market that is ready to plunge.

It is likely that a pullback will occur within a week or two but I see nothing that would suggest that the pullback will be anything but minor.

So pick out a few stocks you would like to own (I'd suggest looking around at Alert HQ, maybe on the Trend Leaders list). There should be an opportunity soon to pick them up at prices 5% to 10% lower than they are today.

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