Topped Out?

Has the market rally ended? Is it time to take profits off the table, to go to cash, or to go short? Time to go into the woods where the bears hang out?

This has been a great rally: The S&P 500 is up 60% since March 9. But it has gone backward in two of the past four weeks, including -1% last week. Hence this article.

As I have stated many times, this has been a sentiment-driven bull market. While it has been more powerful than most, in many ways it is a garden-variety recession bull. Of the previous nine recessions before the current one, the stock market bottomed out and started back up several months in advance of the end of the recession. That's what happened here, starting in March. Why? Because investors were looking forward with hope to the end of the recession and the return of an expanding economy.

I use the term "net news flow" to explain what stock buyers have been reacting to during this bull market. They have been reacting to signs--bits of news--that the economy might be pulling out of the recession. Last March, most any piece of economic data that was "less bad" could be interpreted positively: The downward economic cycle was losing steam and bottoming out--a necessary precondition to the economy turning back upward.

By now, most indicators have slowed their descent significantly, and some have turned upwards. For example, on Thursday the Conference Board reported that its Index of Leading Economic Indicators rose for the sixth straight month. I track several important indicators in my bi-weekly Timing Outlook reports. Those reports have been positive since March, suggesting that the short-term direction of the market would be up. The reports strung out like a chain, and the market did, in fact, go up nearly continuously to its current point.

In the Q2 earnings season in July-August, about 75% of companies reported earnings that were "positive surprises," exceeding the consensus expectations of stock analysts. All of the positive surprises contributed greatly to a positive net news flow that helped the rally along. In most cases, the Q2 reports did not reflect growing revenue or earnings compared to a year ago, or even to the previous quarter. They simply reflected better-than-expected earnings, a low hurdle to clear. Most of the companies cleared it via fast cost-cutting, including layoffs and hiring freezes.

My thought on the market's reaction to the Q2 earnings reports was that investors were giving companies a "free pass" on revenue improvements. You cannot improve earnings forever by cutting costs. My expectation was that investors would not be so lenient the next time around: They would be looking not only for positive earnings surprises, but also for positive revenue surprises and optimistic forward-looking statements.

Lots of people are skeptical about the sustainablitily of the rally. They are uneasy about its sharpness (one of the strongest short rallies in history), unconvinced that it is supported by real economic improvements, dismayed by the seemingly intractable unemployment problem, and disgusted with government involvement via TARP and other bailout programs. They think a correction (a short-term 10% drop) is inevitable, if not an all-out crash if we get a "double-dip" recession.

The Q3 earnings reports started flowing about two weeks ago. So back to the question: How is the net news flow? According to Bloomberg, Q3 earnings are running very positively. By their count, through last Friday, 85% of companies have beaten consensus expectations. Perhaps more importantly, revenues being reported are better than expected, as 65% of companies have beaten consensus expectations for revenues. And a fair number of companies have included positive forward-looking statements on both earnings and revenue.

How to interpret all this? I would say the news flow is slightly positive, maybe a 6 on a scale of 10. Not blowing the doors off, but perhaps good enough to sustain this rally for a while longer.

Frequent readers know that I already have my exit strategy in place for my Capital Appreciation Portfolio. It has three holdings: SPY (the ETF that tracks the S&P 500); QQQQ (the ETF that tracks the NASDAQ); and IBM. The two ETFs are protected by 8% trailing sell-stops that I update each weekend. I have a 10% trailing sell-stop under IBM.

I am comfortable with my sell-stops. If the market turns downward for a prolonged period of time, they will get me out with most of my profits intact. At any rate, it is too soon to declare that the market has topped out. If the market struggles for a couple more weeks, that conclusion may need to be changed. But not yet.

Disclosure: Long SPY, QQQQ, and IBM based on the reasoning given here. Also long about 15 dividend stocks based on an entirely different strategy and approach.

Comments

[a fat panda:]

"Lots of people are skeptical about the sustainablitily of the rally. They are uneasy .... a correction (a short-term 10% drop) is inevitable, if not an all-out crash if we get a "double-dip" recession."

I can't speak for all, but many of the bears see that the government has simply replaced Bear Sterns and AIG in the shadow banking system. The government issues credit via the GSEs and FHA the way the investment banks did, and guarantees it just the way AIG use to with CDSs. This system fell apart because the underlying cashflows didn't support the debt. And we bears don't see that the basics have changed, just the name of the players inflating the bubble.

Oct 26 01:00 AM

[chris coonan:]

the fundamentals of housing are worse than reported, unemployment is worse than reported, government funds are funding a rape/pillage/plunder on Wall Street, and companies are making short term gains based on terminations, unsustainable gov't programs, and restocking cycles....so what makes you think it will only be 10 percent decline....

something is rotten in denmark

when Public and Private debt is unsustainable, and it currently is....and the Commercial Real Estate Market implodes....

America will be looking for a new way to redistribute wealth and prosperity. Coming Soon...

Oct 26 04:14 AM

[thiazole:]

I agree with you. We will be reverting back to the economic data stream ruling the market soon (which I prefer, since broad economic data is easier to predict than the earnings of thousands of companies), and I believe that what the market does from then will largely be determined by what shape this recovery takes on. There are always late-comer earnings that will draw out for another month which can move the market though (seems like Home Depot always moves the market and their earnings are very late in the season).

I suspect that the GDP data from later this week will set the mood for several weeks. If that data is as strong as some have postulated (like Brian Wesbury and Robert Stein), then I think we can expect another strong leg up. If it is as weak as John Lounsbury has predicted, then we can probably expect a correction to the market.

Oct 26 10:54 AM

[BeachRider:]

I agree that there is a strong connection between the health of real-estate and the health of many banks. I also agree that the GDP info is key in establishing whether we could possibly double-dip.

As to the current lack in free-market behavior, that is taking longer than I wanted, too. That is probably for the good, though. Too many free-marketers 'foresee' a quick and inevitable plunge into dismal economic times. Until they find a way to 'sell' a correction to the affected governments, they shouldn't be surprised if those governments choose to hold-onto free market controls for a while longer (remember the 70s?).

Whatever we do, the 'free market' will be adjusted to detect future reoccurrences of too-big-to-fail situations.

Oct 26 11:22 AM