Stock Market Outlook: Breakout! But Then Again ...

by: Eric Parnell, CFA

The stock market brought in the New Year with a bang.

On the first trading day of 2012, the stock market as measured by the S&P 500 Index gained +1.54%. This gain was particularly notable from a technical perspective, as it enabled the stock market to breakout sharply above its 200-day moving average (red line below). After four previous failed attempts over the last few months, Tuesday's advance represented the boldest move yet by stocks to finally advance beyond this heavy resistance level, as the S&P 500 closed 1.5% above its 200-day moving average.

While this was a great way to start out the New Year, the work for the stock market is far from over. The key over the next few trading days to confirm a technical breakout is whether stocks can actually hold above the 200-day MA.

And this is where the "but" comes in. Unfortunately, a variety of factors suggest that the robust gains on the first trading day of the New Year may prove fleeting when it's all said and done.

1. Nothing Has Changed

Tuesday's advance would have been far more encouraging if something meaningful had actually occurred on the global economic front to spark the rally. Instead, the European situation remains just as precarious as ever while saber rattling is increasing in the Strait of Hormuz. And the global economic outlook remains sluggish at best. Thus, today's rally was not sparked by any fundamental change in the outlook.

2. Trading Volume Was Light

Although trading volume was certainly heavier than it had been during the holiday trading week, it was still relatively light. And volumes were hardly at the levels that would confirm that Tuesday's breakout occurred with conviction.

3. Other Markets Have Yet To Confirm the Breakout

The S&P 500 Index, which represents the U.S. large-cap segment of the stock market, is essentially alone in its advance above the 200-day moving average. An examination stocks across U.S. mid-caps (NYSEARCA:MDY), U.S. small caps (NYSEARCA:IWM), developed international (NYSEARCA:EFA) and emerging markets (NYSEARCA:EEM) reveals that all still remain locked below their respective 200-day moving averages. And a dissection of the S&P 500 reveals that upside performance is concentrated among the mega cap names that carry the largest weights in the Index.

4. Treasury Yields Hardly Budged

While U.S. Treasury yields rose on the first trading day of the New Year, the movement was fairly muted. For example, 10-Year U.S. Treasury Yields rose by 9 basis points to 1.97%, they remain locked below the 2% level and are still lower than they were just four trading days ago on December 27. This is hardly the decisive rise in yields that might suggest the whetting of investor appetites for increased risk taking. Putting this into broader perspective, 10-Year U.S. Treasury yields closed at 2.42% at the end of October when the S&P 500 Index last spent a few days above the 200-day moving average. This, of course, is a sizable 45 basis points higher than where they closed on Tuesday.

5. It's The First Trading Day of the Year

We've seen this story play out many times before on the first trading day of the year. And it has been particularly common since the outbreak of the financial crisis a few years ago. In each of the past three calendar years, the stock market advanced by +1% on the first trading day of the year (2009: +3.16%, 2010: +1.60%, 2011: +1.13%). The same can also be said of 2003 and 2006 (2003: +3.32%, 2006: +1.64%). In each of these past five instances, the stock market went on to surrender all of these gains and move into negative territory for the year in the following weeks by early February to early March. And in some cases such as 2003, 2009 and 2010, stocks turned sharply lower in the subsequent weeks. Thus, recent history suggests that gains from the first day of the year may be difficult to sustain in the coming weeks.

It wasn't just stocks that seemed unusually giddy to start off the New Year. Both gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV) experienced explosive moves to the upside on Tuesday. While a potentially better case might be made for the advance in these precious metals given recent developments in the Persian Gulf, both seemed a bit too enthusiastic given the lack of any major fundamental change in view. Unless some major monetary policy action is brewing under the surface to be announced later in the week, Tuesday's gold and silver gains must also be taken with an initial grain of salt.

So while Tuesday's trade was a welcome start to the year, the road ahead remains challenging. Thus, unless we see the recent stock breakout hold in the coming days along with improving fundamentals to support the advance, the latest jump in stocks should be viewed with caution.

Instead, it may be providing an ideal opportunity to rotate current exposure toward more defensive areas of the market, as many of these positions sold off during Tuesday's rally. Leading among these are companies from the Consumer Staples (NYSEARCA:XLP) and Utilities (NYSEARCA:XLU) sectors with stable cash flows and revenues that are largely sourced from the U.S. including J.M. Smuckers (NYSE:SJM), Westar Energy (NYSE:WR) and Alliant Energy (NYSE:LNT). The recent stock advance may also provide the opening to establish positions in Long-Duration U.S. Treasuries (NYSEARCA:TLT), which sold off sharply and continue the consolidation of gains that began back in early October.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Disclosure: I am long GLD, SLV, XLU, SJM, WR, LNT.