With the market having enjoyed a spirited jaunt to the upside to the tune of +15% over the last four weeks and nearly +50% since the March 9th low (for the record, the S&P is up +49.36%), it is fairly obvious that the market has become overbought and just about everyone who has ever hit the buy button is looking for a pullback. Thus, the question of the day is if and when we do get a pullback that lasts more than a couple hours, is it still okay to buy or should we be looking for the exits instead?

I will admit that it is indeed very difficult to buy right now. Everything looks extended and hordes of stocks have simply exploded to the upside. And with the biggest down day over the past month having been -0.56% on the S&P 500, the opportunities to “get in” have been few and far between.

Sure, the mutual funds are clearly buying, which probably explains a lot right now. Remember, as a general rule, these guys don’t spend a lot of time picking their spots on the charts. As a mutual fund manager, when you’ve got a big slug of cash to put to work, your “spot” tends to be viewed from a weekly or monthly basis and not the15-minute chart that the fast-money crowd employs. But, can this environment where stocks only go up REALLY continue for much longer?

The answer, of course, is that Ms. Market can and will do whatever she darn well pleases and frankly, she hasn’t called to ask my opinion of late. It is also important to recognize that the market will do whatever is necessary to confound the most whenever possible. Thus, for those dyed in the wool bears out there who can only focus on how bad things are/were, it must be infuriating to see stocks simply march steadily higher for the better part of the last five months.

But to answer the question; no, stocks probably won’t continue to advance at the current pace ad infinitum. (Way to go out on a limb, eh?) It is a pretty safe bet that at some point – and likely sooner rather than later – something will come out of the woodwork that will give the bears the edge. We would guess that this piece of news will create a fair amount of distress and cause the buyers to simply stand down for a spell. Which brings us to the primary question posed this weekend: After we get a pullback, is it still okay to buy?

The Surge – Part II!

Long-time readers will undoubtedly recall our discussions of breadth surges and the long-term buy signals associated with such an event. The idea is that when the breadth of the market surges to the upside and advancing issues swamp decliners over a 10-day period, the resulting overbought condition is actually healthy and not something to be feared. As we’ve detailed in the past, history shows that such surges in breadth lead to solid advances over the next one, three, six, and twelve month periods.

So, why bring this up now? Didn’t these signals already occur? The answer is yes; we did get breadth surge buy signals in late March of this year. And in keeping with history, the market’s ensuing climb actually exceeded the average gains projected over the next three months.

But without further ado, the point is that the blast from the July low has triggered another round of breadth surge buy signals from a wide variety of indicators. And cutting to the chase, this means that the outlook for the stock market going forward definitely favors the bull camp.

For example, our old standby, the 10-day advance/decline ratio of an equity-only universe flashed a new buy signal on July 21st (the S&P closed at 954.58). History (and the computers at Ned Davis Research) show that stocks have outperformed the normal returns for the S&P 500 over the next months (+3.4% average gain after the buy signal versus the gain of +0.7% for all one-month periods), the next three months (+6.4% vs. +1.9%), the next six months (+12.2% vs. +3.9%), and the next twelve months (+17.2% on average vs. +8.2%).

While the numbers are indeed impressive, as they say, there are three kinds of lies; lies, damned lies, and statistics. So, since average returns can be misleading, we should also point out that such signals are not always profitable. For example, the market has been higher one month after this signal 25 out of 30 times (83.3%). Three months later, the market was up 24 out of 30 times (80%). Six months later, the market was up 26 out of 29 times (89.7%). And one year later, the market was up 27 out of 28 times. Thus, one year later, stocks have been higher after our breadth surge signal 96.4% of the time. (For those curious types, the one 12-month “loser” signal occurred on 1/13/87 – the “Crash” put an end to that run!)

In addition to our favorite breadth surge signal, the McClellan Summation Index Oversold/Thrust Indicator recently issued a rare buy signal (a rise over 2000), the percentage of industries in technical up trends recently hit its highest level since March 2007, and the NASDAQ 10-day advancing volume/declining volume ratio rose to its highest level since February 1991 – all of which suggest higher prices ahead.

Answer the Question, Please

So, armed with fresh buy signals from indicators that have been fairly reliable in the past, it would seem to be a good time to simply load the boat and relax. However, the success of such a plan would depend entirely on your time horizon.

If you are looking out over the next three-to-six months, we feel fairly confident about the prospects for stocks being higher than they are now. However, we should also warn readers that the ride could definitely be bumpy as our cyclical work suggests a fairly stiff seasonal correction during September and October. Thus, if you have the internal fortitude to set-it-and-forget it for the next six months, the odds are definitely in your favor.

If you happen to be looking out over the next year, the odds would again appear favorable. However, given the chances for disappointment on the economic front, we’d be hesitant to play this game very aggressively. As we’ve mentioned, we feel there is a decent chance that the bears return sometime in 2010 in response to an economic recovery that is less than robust.

Finally, for the trader types out there looking out over the next week or two; we can’t help but counsel caution in terms of new buying. While stocks could certainly head higher, the odds of a run-of-the-mill pullback of -3% to -5% would seem to be increasing with each passing day. And last week’s action in the NASDAQ is certainly worth watching from a short-term perspective. Thus, our game plan is to ride with what we’ve got for now and to buy the dips when they occur.

In closing, I recognize that a market that is sprinting higher when you have cash on the sidelines can be disconcerting. Thoughts of missed opportunities undoubtedly will crop up and cause performance anxiety. And the pressure to “do something” can become overwhelming.

However, let’s not forget the big-picture environment. Remember, this is not likely the beginning of a new secular bull market. No, the odds suggest that the current run for the roses is a “mini” bull, which could certainly put up some big numbers after a generational decline. But, there is a decent chance that the bears will return at some point over the next year or so. Therefore, our goal is to make “some” money where we can during this advance and then do our best not to give it all back during the next decline.

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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