With Friday’s Employment report showing that the economy has turned the corner, there is a certain segment of the investing population that may decide it is time to return to the stock market game. From a trading perspective, logic would dictate that anyone looking to buy stocks now might be a little late to the game. After all, the S&P 500 has gained more than 75% over the past year and the major indices are quickly approaching their pre-Lehman levels. Thus, waiting for “proof” that the economy is out of the woods has proven expensive.
However, if history is any guide, the Johnny-come-lately’s may not look so dumb a year from now. While anything can happen in the short-term and a pullback would not surprise anyone at the present time, those investors looking to put money to work do have the odds on their side from a big-picture standpoint.
We’ve talked about something we call a ‘breadth-surge buy signal’ several times over the past year. However, it is important to remember that such signals are both rare and very powerful from a longer-term perspective. As a reminder, our favorite breadth-surge signal occurs when the 10-day total of advancing issues swamps the 10-day total of decliners by a measure of more than 1.9-to-1.
The key point here is that over the past 63 years, stocks have been higher one year after such buy signals 29 out of 30 times (the lone exception was the 1/13/87 signal where the ‘Crash of ‘87’ ruined what up to that point had been a perfectly good buy signal). And looking at a little shorter-term time horizon, the S&P 500 has been higher six months after the buy signal 29 out of 32 times – or 90.6% of the time. Not bad, eh?
We are bringing this indicator to your attention again for a couple of reasons. First, the 29th profitable signal out of the 30 that have occurred since 1947 was confirmed on March 24, 2010 as the S&P was 42.7% higher than it was after the March 23, 2009 signal. And second, the most recent breadth-surge buy signal was given on February 19, 2010. So, while Ms. Market can do anything she darn well pleases in the near-term, the bulls definitely seem to have the odds in their favor when looking out over the next six and twelve month periods.
But… But… But…
Although the bulls have a pretty strong case for wanting to lean long over the next year, we also have found a few things that tell us to think twice about simply bombing into the market right here, right now.
First of all, every trader worth their salt recognizes that stocks are overbought right now and that investor sentiment is becoming a little too one-sided. And we will bet that the recent good news on the jobs front will go a long way toward furthering the bullish sentiment amongst investors. In addition, while not at dangerous levels, we will again point out that valuations in the market are becoming a bit stretched given the current level of earnings, dividends, etc.
Next up, as we have discussed recently, our studies of market cycles show that a meaningful correction in the stock market could begin sometime during the April to September period. More specifically, the composite of various cycles suggests that stocks could top out as soon as April 15th. And while this in and of itself is not a reason to sell, it is something to keep in mind.
While we’re on the subject of historical market tendencies, in looking at the way the market acts after a very strong first year of a bull market that followed a ferocious bear, the risk/reward over the near term appears to favor the bears. In fact, our data shows a better than 70% chance that the market could see a correction that exceeds 10% this year.
What would trigger such a move? In short, we’re watching interest rates (the 10-year is flirting with 4% at the moment), the economic recovery data, inflation, the Fed, and the action of our market momentum models.
Using What We Know…
So, now that we’ve laid out a reason or two to be bullish and at least a couple of reasons to be bearish, let’s see if we can put the data together in order to come up with a plan of attack for the remainder of the year.
Given that stocks are overbought, sentiment is too strong, and our cycle work calls for a meaningful correction to start sometime soon, it might be best to avoid any aggressive buying at the present time. And if you do decide to buy now, keeping a close stop on new positions definitely makes sense.
Next, if our crystal ball is correct and we do see a meaningful correction begin sometime in the next few months, we can use the knowledge that we have breadth-surge buy signals working for us to our advantage. In short, if we do get a good, strong “dip,” we can go ahead and buy when things start to look ugly. After all, with the breadth-surge signal, the odds are on our side that the market will be higher by next February.
To sum up, we’d be cautious buyers from a short-term perspective and aggressive buyers if and when we see a meaningful correction between now and the end of the second quarter.
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