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Saturday, 21 November 2009

Weighing The Facts: Will The Next Leg Be Up or Down?

By Simon Maierhofer

When was the last time you put together a real pros and cons list? Was it back in your dating days, when you purchased your last car, or when you thought about gifts for your mother in law? Regardless of how long it may have been, it's time for another pros and cons list.

Here's why: The stock market has been moving up relentlessly for eight months. Over the same period of time, 3 million jobs have been lost and about one bank a day had to close its doors since the beginning of the year.

Aficionados of technical analysis will find it interesting that the recent 15-day rise came on volume (NYSE total market volume) that was 27% lower than the average volume since March 1st. If you're thinking, stocks are up, all is well; now's the time to snap out of it and face the music.

The implications of this pros and cons analysis will be disturbing, so let's start out with the good news and ease into the subject.

Leading indicators - leading what?

On Thursday (11-19-09), Bloomberg reports that, 'leading indicators point to sustained expansion.' 58 economists polled by Bloomberg forecasted that the Conference Board's index of leading indicators would rise 0.4% in October. The index did rise 0.3%, preserving a string of gains that goes back a few months.

Factors that contributed to a rise in the leading indicators index were interest rate spreads, initial unemployment claims, and stock prices. The pros of the above, offset declines in consumer expectations, building permits, and supplier deliveries.

This index touches a number of areas that are important to an economic recovery, not all of which are leading (meaning the opposite of lagging) indicators. Before we discuss a couple, let's ask one of the tough questions:

Where were the leading indicators in March?

If the leading indicator index is really leading, how did it do in predicting a March market bottom? Chronologically speaking, talks of green shoots didn't pop up until April or later, and the end of the recession wasn't even discussed until July. By that time the S&P 500 (SNP: ^GSPC), Dow Jones (DJI: ^DJI) and Nasdaq (Nasdaq: ^IXIC) had already rallied some 40%.

Unlike the 'leading' indicators and Wall Street which were still in 'recession mode' at the time of the market bottom, the ETF Profit Strategy Newsletter predicted the onset of a major rally via the March 2nd Trend Change Alert. Since the rally was to be the biggest in years, the newsletter recommended loading up on long and leveraged long ETFs.

Such ETFs included plain vanilla ETFs and dividend ETFs with a tilt towards financials, sector ETFs such as the Financial Select Sector SPDRs (NYSEArca: XLF - News) and leveraged ETFs such as the Ultra S&P 500 ProShares (NYSEArca: SSO - News).

The Trend Change Alert was issued weeks before major stimulus packages like the Public Private Investment Plan (PPIP) and governments $1.5 trillion bond-buying initiative were announced. The much discussed bank stress test results weren't published until May 8.

The monster rally explained

According to the ETF Profit Strategy Newsletter, this expected multi-month rally was to be fueled by investor's pent-up urge to buy stocks. This would explain why stocks continue moving up despite an avalanche of bad news.

This pattern of strong declines followed by strong rallies is not unprecedented. After an 18-month decline (October 2007 - March 2009), this urge needed to be satisfied. Furthermore, the initial 48% Dow Jones decline in 1929 was followed up by a 50% rally - as we know today, this 50% rally was the biggest sucker rally of all times, or at least until today.

However, what comes up must come down, especially if the reason for higher prices is merely based on wishful thinking, not actual economic improvements.

Running out of steam

Aside from Thursday's (11-19-09) decline, all looks fine to the casual observer. The big news is that the Dow Jones (NYSEArca: DIA - News), S&P 500 (NYSEArca: SPY - News) and Nasdaq (Nasdaq: QQQQ - News) all pushed to new highs just a few days ago (11-17-09).

Investors tend to over-focus on the three major indexes such as they over-focus on the lead-unemployment numbers (currently 10.2%). Those willing to dig deeper will see that the more comprehensive unemployment rate is 17.5% (U-6 unemployment rate, published by the Bureau of Labor Statistics). They will also find that virtually no other index, or industry sector, has reached new highs.

Small caps (NYSEArca: IWM - News) and mid caps (NYSEArca: MDY - News) are lagging, as are banks, financials, and real estate, the very sectors that have led the prior economic cycles.

Only the best will do

The appetite for risk, visible throughout nearly the entire rally from the March lows, has morphed into a distain for risk. Investors are picking up only the safest of stocks. Aside from blue chips and gold, nearly all sectors and indexes have failed to reach new highs. This is a very bearish short-term development.

Sellers outnumber buyers

Every week, Investors Intelligence (II) tallies up the number of buying and selling climaxes. Buying climaxes take place when a stock makes a 12-month high, but closes the week with a loss. They are a sign of distribution and indicate that stocks are moving from strong hands to weak ones.

Over the past six weeks, 1,410 buying climaxes occurred, more than at any other time in recent history, even more than in October 2007 (see chart above). According to II's research, sellers into buying climaxes are right about 80% of the time after four months.

Too simple to be credible?

Long before high-tech stock analysis and performance simulation programs arrived on the scene, simple, common sense and easy to understand indicators graced Wall Street with their presence.

Perhaps as signs of the time, those indicators are now considered too simple to be taken seriously. Being led in the wrong direction by sophisticated computer programs -none of which saw the post 2007 collapse or March market bottom coming - seems to be popular, but less effective.

The market communicates its intrinsic value to those willing to listen via straight-forward gauges, such as dividend yields and P/E ratios. Dividend yields measure excess cash flow and P/E ratios measure earnings. How much more plain and simplistic can it get?

Point of references that work

Combine those rustic yet accurate valuation measures with history and you have a formula for success. Why? Because every major market bottom (1930s, 1940s, 1950s, 1970s and 1980s) has seen P/E ratios drop to predefined lows and dividend yields rise to predefined highs.

Unless the market reaches those levels indicative of a market bottom, valuations have not been reset and stocks won't be able to stage a lasting rally. In 2002 for example, neither P/E ratios nor dividend yields reached those predefined levels, therefore resulting in new lows earlier this year.

Just as ice doesn't melt unless the temperature rises above 32 degrees, the market doesn't rally unless the trigger levels are reached.

The current P/E ratio, reported by Standard and Poor's (based on reported earnings) sits at 85.55, way above the historical average of about 20. Dividend yields have dropped close to their 1999 all-time lows (remember what happened shortly thereafter - the Nasdaq tumbled 80%).

Looking at the pros and cons of the market's prospects, it becomes clear that a freezing cold environment lies ahead.

The November issue of the ETF Profit Strategy newsletter plots the historic performance of the stock market against P/E ratios, dividend yields and two other trusted indicators, along with target levels for the ultimate market bottom. A picture paints a thousand words and those charts speak volumes about the market's future.

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