Market Surge: The Party's Not Over, But Keep an Eye On the Door

A two-month surge has placed the stock market in a very overbought short-term condition, but the weight of the indicators we track, which are reviewed below, do not yet suggest that an important top is at hand.

The S&P 500 appears poised to challenge its previous all-time high set back in early 2000, which is less than 3% away from current levels. Despite an overall backdrop that remains supportive of higher stock prices, the strong rally over the past two months has caused the risk/reward profile of the stock market to deteriorate.

As a result, we have reduced risk slightly in our managed portfolios, but the evidence suggests that it is still premature to implement major defensive strategies. As one analyst we follow recently stated, it is too early to leave the party, but it is a good idea to keep track of where the door is. With stock indexes stretching the upper boundaries of their well-defined, multi-year upward price channels, it is most certainly a time to be very careful committing new money to the stock market.

Technicals
Along with highly favorable supply/demand conditions (discussed below), the technical action of the stock market continues to make a strong argument for maintaining a bullish posture. Most indices are trading at new bull market highs, and the momentum of the recent advance has been nothing short of remarkable. During the entire upward move off the mid-March lows, the S&P has not dropped more than 20 points from a high.

While the rally continues to be broad-based, there are preliminary indications that breadth is deteriorating. Although the Dow and the S&P 500 have been making new highs on a weekly basis, the small-cap averages have struggled to move to new bull market highs, and the overall advance/decline line has weakened somewhat. Deteriorating market breadth (i.e. a decreasing number of stocks participating in the advance) and "divergences" in the form of certain indexes and sectors breaking down or failing to confirm moves to new highs are two of the earliest and most reliable of bear market warning flags, so we will continue to keep tabs on these valuable technical indicators.

"Supply/Demand" Dynamics
Supply/demand dynamics continue to be very favorable for the stock market, with cash acquisitions and share repurchases "shrinking equity" supply at a record pace, and relatively light new stock offerings limiting the amount of new supply coming to market. The equity shrink resulting from stock buybacks and cash acquisitions is a powerful force in the markets, driven by the positive spread between earnings yields and interest rates.

As long as credit remains cheap, and the outlook for earnings remains constructive, private equity and corporate buyers will keep coming after public stocks, though it is hard to imagine deal activity getting any more frenetic than it is today. Year-to-date, an astonishing $2 trillion of global mergers and acquisitions deals have been announced. April was the busiest month in the history in the M&A business with the announcement of $650 billion worth of deals. Global M&A activity in 2007 is running 63% higher than in 2006. In the U.S., cash acquisitions of public companies since January 1 are more than twice last year's pace..

Sentiment
Sentiment analysis tells us that the stock market is a manifestation of mass psychology in action and that a top in the market is the point of maximum optimism. By this definition, the M&A/LBO environment is sending a distinctly cautionary signal, but other measures of investor psychology, particularly at the individual investor level, suggest that while bullishness is getting high, it is not yet at the optimistic extremes normally found at market tops.

In fact, certain measures of sentiment show a surprising degree of skepticism in light of the very bullish action in the stock market. The most recent weekly reading from the AAII sentiment survey, for example, shows that bullish and bearish respondents are about evenly split at 43%.

Another measure that suggests that individual investors are hardly euphoric towards the stock market is the flow of funds into equity mutual funds and ETFs. Year-to-date, retail investors have directed more dollars into money market funds than U.S.-focused stock funds and ETFs, and the volume of fund flows into both U.S. and foreign stock funds is running about 30% below last year's pace.