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The first trading day of August saw two equity indices reach major milestones, a rare occurrence. The S&P 500 index closed above the 1000 mark for the first time since last November, while the Nasdaq composite closed above 2000 for the first time since last October.

The S&P 500 has rallied almost 50% from the lows reached just five months ago. Under normal circumstances, such a move would be a sign of a raging bull market. However in spite of the historic rally, a lot of pundits still question whether this is a bear market rally or a true bull market.

Where Is the Volume?

One major reason for their skepticism is the lack of market volume. Typically during bull markets, the volume of shares traded increases as the market moves higher. However in this rally of the March lows, the volume has been decreasing as the price moved higher. Proprietary indicators developed by Lowry’s Research show a lack of what they call buying pressure; the market moved is based primarily on lower selling pressure since the March lows.
However, at the end of the day, the only metric of real-world significance is the price-action. And the price-action has been very strong.

Technical Theories: Buy Signals Everywhere

Equity indices have been on a tear since the swing low reached in July, moving up double digit percentages in two weeks. During this period a lot of technical signals which indicate a bull market have turned green. The 200 day simple moving average (DSMA), an indicator of the long term trend, started sloping up in late July. The 50 DSMA, is also sloping up and is well above the 200 DSMA.
July was also an outside reversal month. Equity indices undercut the lows of June, but then reversed to close at a new high. During the recent bullish run, the number of stocks making new short-term highs has increased to new highs, signifying a broad-based rally. According to Dr. Brett Steenbarger, today 1829 stocks made a 65 day (13 week or 3 month) high, while just 105 stocks made a 65 day low. This is a new record for this bull market.
After the failure of the head and shoulders topping pattern in early July, the S&P 500 has broken the neckline of an inverse head and shoulders pattern, which has been forming on a much larger time-scale. This article written by a trader I respect a lot, discusses different aspects of this pattern. Her target for the completion of this pattern is 1229, a good 23% above the current price.
The Slow Turtle trading system compares the 22 week moving average with the 55 week to capture long term trend changes. It generates a buy signal when the faster average crosses up over the slower average and a sell signal when the reverse happens. Nasdaq100 is making that cross this week, while the SPX is fast approaching that level.

Richard Russell’s Interpretation

This article discusses Richard Russell’s interpretation of the Dow Theory and the buy signal it generated. Quoting Mr. Russell’s letter, it states:

“… My interpretation? We are now in a cyclical bull market as opposed to a secular or primary bull market. In effect, we’re in an extended bear market rally. The true bear market bottom lies somewhere ahead.

“There is no way of knowing how high this bear market rally might carry. The question - is it worth playing this cyclical bull market? My answer is yes, but play it very conservatively and carefully.”

The last sentence captures the essence of investing in this market.

The Chinese Experiment: Reengineering Chinese Consumer Preferences

The rally has been driven by expectations of continued growth in emerging economies (primarily China) as a result of the massive government stimulus injected into those economies. It is based on the expectation that growth in the emerging markets will help cushion the effect of the credit-led slowdown in the developed economies. The roaring bull market in commodities and technology stocks is an indication of this bias.
The Chinese economy is joined at the hip to the Western consumer. The Chinese Communist Party is trying to separate the two using its fiscal policy as the scalpel. The CCP hopes that the massive stimulus spending on infrastructure will compensate for the loss of export jobs and incentives to encourage consumer spending will grow domestic consumption.
There are strong indications that many loans have been granted without due diligence about the viability of the investments. There are murmurs that at least 15% of the loan amount has been siphoned into Chinese equity markets which are up almost 85% this year. Whether CCP’s growth at all cost style of managing the economy will work is yet to be seen. Risking whatever is left of your nest egg on the potential success of CCP’s experiment of reengineering consumer spending attitudes is a dangerous game, which has to be played carefully.

Navigating the Markets

In my July 14 article after Intel’s earnings, I had expected another leg up in the equity markets with an initial target of 1000 on the SPX which has now been met. The now failed Heads and Shoulders pattern had trapped a lot of trading account short. This resulted in a massive-short covering rally with hardly any pullbacks, with the Nasdaq100 (QQQQ) closing up for 13 days in a row.
Once the stock indices made highs for the year, they have attracted more sideline money as the rally builds on itself converting more skeptics into believers. Though the initial burst was led by technology stocks, the rally has broadened with low P/E value stocks also participating.
The SPX is approaching a key Fibonacci Retracement and the highs of November 2009 around the 1007 level. It is likely that the market will face some resistance here, and pullback. The pullback may go back to the 950-960 level which forms the neckline support of the inverse head and shoulders pattern.
In April, I had written an article describing how more money will come into the market as it crosses key technical levels. Assuming the 950-960 level of support holds, I expect another bullish run, which is likely to suck in a lot of sideline money. The ensuing rally is likely to be strong and perhaps on better than average volume. However, I see this as a melt-up kind of rally where mutual fund money chases equities not because of some newly discovered confidence in the underpinnings of the economy, but because of the fear of underperforming the broad market.
Jeremy Grantham of GMO, who had correctly predicted a liquidity driven stock market rally this summer, feels that equity markets are at or near fair value and are starting to overshoot. In his quarterly letter (registration required) he is advising clients to go underweight in their equity portfolios if and when SPX is between 1050 and 1100.

Sentiment Is Key

Given the shaky underpinnings of this rally, I strongly believe that investors should focus on the market sentiment more than anything else. When the market ignores bad news, but rallies on good news, it is relatively safe to be invested long.
During the July rally, the market shook of below expectation results (or forecasts) from major bell-weather stocks like Microsoft and Amazon. A downward revision in the first quarter GDP number or the continued high level of first-time jobless claims did not slow it down. The dollar continues to be sold, and risk appetite seems to be rising.
However, the wall of worry put up by the underlying economic figures looms high and sentiment can turn on a dime. While the rally is likely to continue, investors should follow their trading plan consistently and set hard stop levels, to limit capital-erosion. The market has also rallied almost 50% from its lows, and averaging down carries a lot more risk than it did a few months ago.
Source: SPX 1000, Nasdaq 2000! But What Next?