Are Stocks Poised For Another Melt-Up Rally?

Includes: EWG, EWI, EWP, QQQ, SPY, XLU
by: Chris Ciovacco

The current rally in stocks is relatively simple to explain. Hedge funds and institutional managers believe the Europeans are on the verge of a significant debt crisis breakthrough. If that is the case, a twenty-seven month bearish drag on the market is about to be removed. If a twenty-seven month drag is about to be removed, it stands to reason stocks could continue to push higher in the coming months.

If you are looking for concrete proof of a shift toward "risk-on", the chart below of Spanish yields is an excellent place to start. Falling bond yields are indicative of an increasing confidence in Spain's ability to repay its creditors, which is the main concern in a debt crisis.

In the chart below, points A, B, and C clearly illustrate the market's number one concern over the past twenty-seven months… Europe. Notice how market peaks coincided with bad news from Europe. The reduction in fear, shown via boxes D and E, tells us the market's (NYSEARCA:SPY) number one burden seems to be getting lighter.

The European debt crisis moved to the top of the market's worry list on April 23, 2010 when Greek Prime Minister George Papandreou called for a eurozone-IMF rescue package following a steep rise in borrowing costs (see point A in chart above). Some better-than-expected economic data and QE2 pushed stocks toward point B in 2011, only to be derailed by a European commission report stating Greece's budget deficit was worse than expected. With the markets extremely vulnerable in late 2011, the European Central Bank stopped the bleeding with unlimited three-year loans for banks. The green box labeled D above shows the S&P 500 making a higher low relative to the 2010 low, which marked a turning point in the minds of investors. The European "derail theme" returned near point C when Spanish bond yields began to rise sharply. Talk of more intervention from the ECB allowed stocks to put in a much higher low above box E; higher lows illustrate decreasing concerns about Europe.

On the technical front, numerous European stock markets have a potentially bullish set-up known as an inverted head-and-shoulders pattern. In the chart of Spanish stocks (NYSEARCA:EWP) below, the small size of the right shoulder relative to the left shoulder shows a significant reduction in the fear of an implosion in Europe. Similar bullish set-ups are in place for German (NYSEARCA:EWG) and Italian stocks (NYSEARCA:EWI).

Bullish set-ups and signals similar to early melt-up periods in 2009, 2010, and 2011 are covered in the video below for the S&P 500 (00:50 mark), utilities (NYSEARCA:XLU) relative to stocks (01:30), NYSE Composite (03:15), stocks relative to bonds (06:01), tech stocks (NASDAQ:QQQ) relative to S&P 500 (07:37), RSP (08:57), (EWG) Germany (11:01), (EWP) Spain (11:01), (NYSEARCA:VEU) (12:38), NASDAQ (14:46), Dow (15:09), (IWM) small caps (15:29), (MDY) mid-caps (15:47), (XLB) materials (16:04), transportation stocks (16:34), (GLD) gold (17:06), (SLV) silver (17:42), (TBT) short bonds (17:51), and Russell 2000 (20:32).

After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.

The major stock exchange in London also reflects increasing optimism about the ECB's bond market intervention plans.

As we noted on July 2, Germany's increasing acceptance of additional bond market intervention from the European Central Bank is a watershed moment in the twenty-seven month crisis. We have been open to better than expected outcomes since late May, and we continue to believe a "monster" rally could occur in the coming months. A few hurdles remain in Europe, which means a market pullback remains possible. As long as the ECB is making progress on the bond buying front and the charts point to favorable outcomes, we will remain positioned for a risk-on environment.

Disclosure: I am long EWG, EWI, EWP.