Was January a Sucker's Rally?

Includes: IEI, SH, SPY, TLH, TLT
by: Jeffrey Dow Jones

The market's up about 3.5% for the year so far. Not a bad way to kick off 2011!

But is it a sucker's rally?

Let's take a look at the internals and some other indicators to see if we can answer this question.

One of the best proxies for risk in the global credit markets is the LIBOR-OIS spread. It measures the difference between LIBOR, which is a floating rate, and the overnight indexed swap rate, which is fixed by the central bank. So it's a spread between something risky and something stable. I think of it as kind of a barometer for the level of jitteriness that bondholders and banks feel about the market.

[Click all to enlarge]
Click to enlarge
Source: Bloomberg

It's still nowhere near the highs of the European Debt Crisis last summer, but it's been slowly, steadily trending up since December. This is interesting because the market has been rallying fiercely higher alongside it.

The TED spread (short term U.S. Treasuries vs. eurodollar futures) is another way to get this done, and it's telling a somewhat similar story. It bottomed out in November and has been trending up since then with a mini-spike here and there.

In recent years, the euro/yen cross has become another one of my favorite indicators for the total level of global risk aversion. When it goes up, it usually means that investors are in a risk taking mood and when it falls (a preference for the "safety" of the Japanese yen) it means that investors are feeling more risk averse. Be careful using it as a market indicator, though. It's usually a little early.

Click to enlarge
Since the enthusiasm of the QE2 rumors began circulating early last fall, the euro/yen cross has slowly been trending downward. I'd feel a lot better about this current rally if it had pushed this cross towards some new highs.

We know that investor sentiment is high right now -- almost historically so. A whopping 51.5% of participants are bullish on the market, according to the latest AAII sentiment survey. This survey is one of the favorite contrarian indicators of many Industry insiders. So when it gets supe-super-bullish it often means that a correction is near. Wall Street always prefers the safety of the herd.

And then there is the percent of stocks above their 200-day moving average. This is another good contrarian indicator, and it's one of the best barometers in the world to tell you when the market is overbought and when it's oversold. It's not easy to do, but generally speaking, it's a whole lot more profitable to buy the market when it's oversold and sell it when it's overbought.
Click to enlarge
As you can see, early 2009 was a tremendous time to buy stocks, and last summer wasn't so bad either. But those were both psychologically challenging environments to do such a thing. What's interesting is that the peaks have been slowly declining for almost two years.

That's a lot, by the way. Over 81% of stocks above their 200-day moving average. The market is very extended at present.

The percent of stocks above their 50-day moving average is telling a similar story. This is usually the first one to break down or break out, too. It's been trending down since late December, while the market has surged onward to new highs.
https://staticseekingalpha.a.ssl.fastly.net/uploads/2011/2/3/524360-129674536953313-Jeffrey-Dow-Jones_origin.pngClick to enlarge
And lastly, pay attention to volume. Lately, the biggest volume days have been the down days. That's one of the first things they teach you at technical analysis school: Be wary of rallies on light volume and afraid of declines on heavy volume.

Anyway, there's a lot of under-the-radar in the market right now, revealing that things are not quite as positive as one might think after simply looking at the headline indexes. This market is being carried higher by momentum and momentum stocks, and those are usually the last to turn around as a correction approaches. They do it quickly, and dramatically too.

If you want to play the market to go higher, you can own the S&P SPDRs (NYSEARCA:SPY), though you'll get more bang for your buck (and more risk) with something that has a little more momentum behind it.

I think a better 6-12-month tactical trade is to step to the sidelines for now, or if you're aggressive, think about an inverse ETF like the Proshares Short S&P (NYSEARCA:SH). You can also pick up some bonds in the meantime too. Something like the Barclay's 3-7 Year Treasury Fund (NYSEARCA:IEI), which should get a nice little kick if the market freaks out a bit and interest rates dip back down again. The 10-20 Year Treasury Bond Fund (NYSEARCA:TLH) will give you even more oomph in that instance and something like TLT (20yr+) can be used effectively by all you real pros out there.

Once you've done that, just hang out for a little bit until the correction happens and stocks are selling below their moving averages again. Go get lost in a great book or hit the ski slopes for a while. Watch for the "all clear" from the risk indicators we just talked about again, and then load back up with equities. That all requires some patience, though, which is difficult. And then it requires you to buy when things are looking ugly: Also difficult. Nobody said this making money thing was going to be easy, despite Ben Bernanke's heroic efforts to make it so.

There aren't any red flags flashing right now, but there are definitely some yellow ones. We'll have more to say about this as the story unfolds.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in IEI over the next 72 hours.