There are lots of reasons to be bullish on the stock market these days, not the least of which is the +12.3% spike higher in the S&P 500 over the past 15 trading days. In short, there is nothing quite like big blasts to convince people to hop on the bandwagon as more and more investors seem to be worshipping at the altar of price momentum these days.

While we will readily admit that stocks are overbought and due for a rest from a short-term perspective, from a big picture standpoint, there are a bunch of reasons to be optimistic about the future. For starters, our indicators suggest that the recession ended in either June or July. Sure, the recovery may be weak. But anyone who has been around the game a while knows that the time to invest in stocks is BEFORE the official word is given that a recovery is underway.

Next up, the Q2 earnings season has clearly been better than expected as company after company has come in with results that beat the estimates. Yes, yes, we know about the complaint that the primary reason earnings are better is due to cost cutting measures (which, in English, means layoffs). But Wall Street is a cold hearted place and the bottom line is if earnings are better than had been expected, then stock prices go up – it’s that simple.

Then there is the idea of mutual fund managers putting money to work. With very few individual investors in the game these days, about the only way to produce a string of consecutive up days such as the one we saw recently on the NASDAQ is for big mutual funds to be moving cash from the sidelines into stocks. We saw this happen early in the spring and we believe we are seeing it again now. And one of the best arguments for stocks continuing to run from here is to remember that mutual fund managers aren’t chart watchers on a day-to-day basis. They simply start buying and then keep buying until their positions are built.

Next is the fact that history favors the bulls right now. As we pointed out this week, Bloomberg reported a big buy signal for the DJIA on Thursday as the Dow moved to 10% above its 200-day moving average after being more than 10% below the moving average. Bloomberg said since 1921, the Dow has moved higher after the signal 18 out of the 21 times and that the index was up nicely over the next three months as well as the next twelve months.

Sticking with history, we should also keep in mind that after a 15% quarterly gain (the S&P gained +15.22% in the second quarter of this year), the S&P has been higher twelve months later 8 out of 8 times since 1942 and 11 out of 15 times since 1929.

Speaking of buy signals, we’ve seen (and previously reported on) a big batch of reasons to be bullish over the last five months. We’ve seen relatively rare surges in breadth, something called a “golden cross,” and any number of chart patterns flash signs that it is time to buy.

So, with word that the economy is improving and that earnings are a bit better than expected, it is little wonder that there now appears to be a stampede of buying taking place.

How High is High?

But (you knew that was coming didn’t you?), the key questions we’re now asking are: (1) How high is high? And (2) how will we know when to leave the party?

While I do apologize for bringing up such negativity on a glorious Sunday morning, the trick to this game is to be most optimistic at the bottom and most pessimistic at the top. And after a run up of +45.96% on the S&P 500 since March 9th, we think it might be time to start thinking about an exit strategy – BEFORE the party gets out of hand.

The question of how far a bull market can run is always a tricky one. So, we’ll take a couple of different approaches and see if we can come up a hint or two as to the when it might be a good idea to leave the party.

The first thing we should remember is that the overall environment is one of a secular bear. Thus, this is NOT the time to set-it-and-forget-it or resurrect those buy-and-hope strategies that were so popular during the secular bull environment that started in 1982. Given this assumption, we note that the average gain of what we call a “mini” bull market (a bull run that takes place within the context of a secular bear market) has been a smidge over +65%.

If we do some simple math and tack on a gain of 66% from the March 9th low of 676.53 on the S&P 500, we come up with a projection of 1123. Thus, it is worth noting that this target is about +14% above where we closed on Friday.

Next, we can apply the Fibonacci retracement levels as a way to search for a logical turning point. If we take the difference between the top in October 2007 and the bottom of March 2009, we see that the bears lopped off 889 points from the peak of S&P. If we then apply the Fibonacci sequence and assume that stocks will retrace anywhere from .382 (we’re rounding here) to .618 of that drop, we come up with targets (on a weekly basis) of 1018 (the .381 retracement level) and 1226 (the .618 level). These levels are +3.1% and +24% higher respectively from Friday’s close.

Finally, while valuations aren’t necessarily our area of expertise, let’s take a shot at it to see if we can narrow down the gap of upside projections. If we assume that the S&P 500 will earn $60 next year (a number we borrowed from Ned Davis Research) and that a P/E of 20 would be considered “fairly valued” (also a measure we borrowed from NDR), then 1200 on the S&P 500 might be a level to watch. And just to complete our current exercise of fun with numbers, the 1200 level is +21.5% from Friday’s close.

Thus, we can argue that, at a minimum, there is somewhere between +14% and +24% upside remaining in this “mini” bull before the bears start growling again.

What’s Your Exit Strategy?

On that happy thought, perhaps I should just leave well enough alone and go work in the yard this morning. However, we are of the opinion that risk management will be an important strategy again sometime next year. With debt levels still VERY high and the consumer having changed their spending patterns (spending less, saving more, and incurring less debt), we can’t help but feel that the bears will make a comeback after the recovery becomes official and/or the earnings gains from cost cutting begin to dissipate. So, the question becomes: What’s your plan to leave the party?

Since the idea of predicting when a bull will end is a fool’s game, we aren’t going to drag out the crystal ball and attempt to make any bold predictions toward this end. However, we WILL lay out a set of parameters that might cause us to think about switching to a more risk averse mode.

First and foremost, any significant increase in interest rates and/or inflation would definitely give us pause. Next, a downturn in the breadth of the market – which we’ll define as the number of industries that are technically healthy – would be a reason to become cautious. And finally, in light of the fact that Wall Street tends to overdo moves in both directions, if we see extreme optimism in our sentiment indicators followed by a reversal lower, we may want to start thinking about looking for the car keys.

Wishing you all the best for a profitable week ahead,

David D. Moenning
Founder TopStockPortfolios.com

Positions in Stocks Mentioned: None

 

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