Why I've Never Trusted This Rally

 |  Includes: DIA, QQQ, SPY
by: Sean Hannon

Investing can be very complex. Examining a series of different opportunities, pondering different scenarios, and determining which actions should be taken require a great deal of focus and thought. When a decision is reached, the last thing we want to do is spend hours explaining and rationalizing our actions. Instead, simple phrases and quick antidotes are developed.

For contrarian investors who prefer taking non-consensus views, one phrase almost always sits on their lips- "this time is different". While a simple and effective explanation, that phrase has led to more loss and heartache than any other four words. During the dot-com bubble, investors rushed into internet stocks with non-existent business models since anything on the web was sure to see exponential growth. Losses quickly followed as the old rules of revenue and income being needed to support a business had not been violated. Those who snapped up subprime mortgage REITs during the credit bubble ignored the facts that borrowers with no income or assets cannot pay their mortgage. The carnage from that disaster still reverberates through the housing market. Those who felt the rules had changed and this time was different quickly learned otherwise.

As I have watched the current massive rally build upon itself, I have underestimated both its breadth and duration. I have never fully trusted this market. So much of the information we receive is distorted by the unprecedented fiscal and monetary stimulus that it is difficult to determine if the economy has truly turned the corner or if another move lower awaits. For now, the bulls are banking on a seamless transition from government demand to private sector demand. It may occur, but few have considered the risks if it does not.

Throughout this rally, I have taken my cues from the market. Perhaps this time was different. Perhaps governments could create prosperity by cranking the printing presses and running tremendous deficits. Perhaps all of us who worried about the future should have abandoned our inhibitions and jumped on the bull's back. Perhaps runaway deficits will not impact long-term economic growth.

For nearly a year, the market has indicated that this was the right approach. Every dip has been bought and every piece of negative information spun positively. On occasions where it looked like the market was peaking, the rally resumed.

During this process I have looked for markets moving in tandem to signal the power of the rally. When we see many markets confirming one another, it shows that investors desire risk and the underlying trend is intact. When markets move in opposite directions, it shows signs of selective enthusiasm that often mark a top.

Last week was powerful for North American markets with all six of the indices I track reaching recovery highs. However, the enthusiasm was contained as Europe and the emerging markets were weak.

Before we declare that a market top is forming, consider that we have been here before. During the past year, markets have often shown signs of topping, but have righted themselves and resumed rallying. For now, prudence requires we give the bulls the benefit of the doubt, but caution is needed.

The Dow Jones Industrial Average and S&P 500 are within 51 and eight points, respectively, of key Fibonacci levels. Meanwhile, the market remains overbought. These data points do not signal a market that must decline, but does warrant caution. An overbought market approaching resistance is not the best entry point so we must question the source of incremental strength.