Play the Rally, Not the Correction

 |  Includes: AAPL, AMZN, GOOG, NFLX, QQQ, SPY
by: Andy Zaky

After rallying for 61 trading sessions without a meaningful pullback, can the S&P 500 (ETF:SPY) really move higher for another 5 months? Is today’s decline the start of something bigger, or just a pause ahead of further moves ahead? While it is true the market may be sitting at the brink of a correction, history also teaches us that this currently rally could last significantly longer than many bears suspect.

research study conducted at Cobra's Market View - a publication focusing on technical analysis - revealed that over the past two decades there were only 16 other rallies where the S&P 500 moved higher for at least 40 trading sessions without a 2.5% pull-back (see here). Nearly 90% of those rallies ended with some sort of a retracement by day 61 - precisely where we are today - with only two out of those sixteen rallies continuing higher for longer than 61 trading sessions.

Yet for the two rallies that did continue higher - 1995 and 2006 - the S&P 500 went on a massive 150-day bull run without a solitary 2.5% pull-back. As of the close on Monday, this current rally stands at exactly 61 trading sessions, which happens to be at the high-end of the range, and the threshold at which 90% of these rallies ended. Below is a list of every major rally from 1992 to 2011:

Click to enlarge
source: Cobra’s Market View

Click to enlarge
source: Cobra’s Market View

Notice how only one other rally - that didn’t turn into some massive 150-day bull run - managed to stretch to exactly 61 trading sessions (2005). And even that rally was followed by a moderate 3.3% sell-off. According to this historical record, it would seem that the equity markets should see some sort of a steep decline this week.

Even recent history tends to suggest that the market is at the eve of an immediate correction. Two of the above-mentioned sixteen rallies actually transpired over the past 12 months. The first took place in the 54-trading sessions after February 5, 2010 and ended with the May 6 flash crash. The second began on September 1, lasted 49 trading sessions, and ended with a mild 4.6% correction in November. So even the most recent rallies respected the long-term historical trend.

Thus the big question this week is are we standing at the precipice of another sell-off, or is this only the beginning of some monumental bull run witnessed only once in a decade? While the historical evidence appears to support the conclusion that the market is likely headed for a pullback, here’s why it doesn’t pay to be a bear:

Even if the market does see some sort of a correction off of these levels, the correction would most likely be relatively mild. With the exception of only a handful of cases, these post-rally sell-offs have invariably been in the 3% - 5% range (see above). And that’s because whenever the S&P 500 experiences a rally of such magnitude, it takes a tremendous amount of effort to slow that momentum.

Moreover, the market almost always retests its highs before seeing any sort of a real 10% correction, making it even less likely that we see a big sell-off right off of these levels. In only two cases did the market immediately undergo a 10%+ correction right off of the highs – once in 1993 and the other was after the May 6, 2010 flash crash.

So by taking the risk of a potential 3% to 5% draw-down, investors could potentially capitalize on a once-in-a-decade bull-run. We are in as good of a position as any to see the markets continue rallying for 150-days straight. The power of quantitative easing has been clearly demonstrated in the sharp advances in the equity markets, first in March 2009 and again in August of 2010, the S&P saw mind-numbing moves higher on the back of QE.

Just the threat of quantitative easing is enough to get these markets going on humongous bull-runs. And with QE2 set to continue through the end of June, I wouldn’t be shocked to see the S&P 500 continue much higher until Bernanke clearly outlines his exit strategy.

Even if we do end up seeing a 10% correction off of these levels, Bernanke the Bear Slayer clearly has his finger on the QE trigger, and isn’t afraid to shoot. By holding the bears hostage at gunpoint it is unlikely that the markets will see any sort of extended selling pressure until it is clear when the Fed plans to end its buy program. At some point the markets will have to pay for the so-called “Bernanke Put” - I’m putting my money on 2012 - but until that time, there is no reason not to take advantage of this market which is likely to see 1,400-1,500 sometime before Bernanke takes the market off life-support.

Five Stocks & ETFs to Watch in 2011

While the S&P 500 has performed admirably - rallying nearly 27.8% since Bernanke’s Jackson Hole speech in late August - the Nasdaq has been by far the biggest beneficiary from this deluge of cash injections into the markets. Below are five stocks to keep an eye on in 2011.

1. The NASDAQ 100 (QQQQ)
The ETF tracking the NASDAQ-100 is up a whopping 37% since August, and I don’t expect to see any sort of a slow down heading into 2012. In fact, the NASDAQ-100 has not only fully recovered its losses during the financial crisis, but it has far surpassed the highs set in the previous bull market, hitting levels not seen in over 10 years. This is due in large part to Apple’s (NASDAQ:AAPL) nearly 500% move since January 2009. As Apple makes up nearly 20% of the NASDAQ-100, it shouldn’t be much of a surprise to see the index at 10-year highs. For those interested in participating in the broader tech market, the NASDAQ-100 is the place to be.

2. Apple (AAPL)
Speaking of Apple, the stock is still considerably undervalued even at $360 a share, and should see $500 sometime before the close of the year. With a very cheap .76 PEG ratio, Apple continues to decimate all expectations, trades at only 13 times next years earnings, and should continue to grow at a significant pace over the coming years. With the stock set to record over $100 billion in revenue this year, don’t be surprised to see it trade between $700-800 a share before the end of the business cycle - even despite worries over the company’s market capitalization.

3. Google (NASDAQ:GOOG)
Another stock with great value is Google (GOOG). Though the stock is up considerably in 2011, this is one of the best comeback stories in tech. Inching ever closer to its all time highs set before the financial crisis, Google should see fresh all-time highs before the end of 2011. Trading at only 15 times next year’s earnings and in line with its 5-year expected growth rate, the stock is a great long-term investment.

4. Netflix (NASDAQ:NFLX)
Though the stock (NFLX) is a bubble trading at nearly 80 times last year’s earnings, momentum is clearly behind the stock. As long as the company continues to exceed expectations, momentum traders will continue to turn a blind eye to valuation concerns. Moreover, as long as Bernanke has his finger on the printing press, expect to see this stock at $300 a share sometime over the next several months. Yet when the tide turns on this one, it's going to get hit hard. But that could be months or even years away in this inflating market.

5. Amazon (NASDAQ:AMZN)
Like Netflix, Amazon (AMZN) is clearly in a bubble trading at 75 times last year’s earnings. But unlike Netflix, Amazon appears immune even to bad news. Despite disappointing investors a few weeks ago on earnings, the stock is still within striking distance of fresh all-time highs. This is the only stock that I’ve seen which rallies on earnings misses. In late July 2010, the stock misses expectations, gaps down almost 20%, and then fully recovers inter-day. In late January, the stock tumbles on bad earnings and then rallies 10-straigh sessions to near all-time highs. As long as the stock can get above its previous resistance at $190 a share, Amazon could potentially make a run for $250 or higher.

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