Every time a major stock index approaches a new high, invariably we can find calls that "a major top has already been made". We have seen several such articles in recent weeks. While these incessant calls for a major top may be 100% accurate at the present time, a review of historical major tops gives little support for such a claim. A short-term top within a major bull market can occur at any time, but major tops do not occur very often.

Fundamentals Are Improving: We also have to consider improving fundamentals when constructing a case for a major top in stocks or the lack thereof. Thursday’s unemployment report came in better than expected, but more importantly the four-week moving average of jobless claims dropped to its lowest level in almost a year. Third quarter earnings that came in above expectations, beat those below expectations by a ratio of 6-to-1. Admittedly, earnings estimates in Q3 were conservative, and employment will remain weak for a time, but recent data does suggest some economic improvement.

Investors Are Wise To Remain Flexible: The bearish spin on unemployment is obvious. The bullish spin is weak employment means low interest rates which is good for asset prices. Another possible spin by the bulls is "sell the rumor (weak employment) and buy the news (Friday's report)". Ultimately, it matters how the market (in the collective minds of participants) chooses to spin it, not how we at CCM choose to spin it. Nor does it matter how any one individual, one columnist, one market guru, one money manager, one firm, or one talking head chooses to spin it. The market sets asset prices, not individuals or gurus.

You'll hear a lot of "the highest unemployment rate in 26 years" in the next few days. Keep in mind, 26 years ago was 1983, another period of negative investor sentiment. Sentiment is a contrary indicator – markets do well when people are pessimistic. Stock market performance from 1983 to 2000 is shown below to stress the importance of keeping an open mind as you read all the gloom and doom articles in the coming days. An open mind means open to bullish and bearish outcomes, despite negative sentiment. An open mind, means remaining flexible enough to react to bullish or bearish conditions as new information comes to light, both via the news cycle and the market's reaction to the news.

In the last two weeks, in Reflation Supported By Stocks, Commodities, and Oil, and Gold, Recessions, Bonds, and 1987, we hypothesized that recent bullish moves in gold, oil, and the CRB Index were evidence of successful "reflation" of asset prices via monetary and fiscal policy. This week, we can add copper and emerging markets to the bullish evidence list. From a fundamental perspective, the desire to hold copper is based on economic need (you want to make a product), and inflation protection (you want to own hard assets rather than paper currencies).

Copper and Emerging Markets Are Worth Monitoring

Last week in Gold, Recessions, Bonds, and 1987, we stated that:

• A major objective of all the money printing, government intervention, and low interest rates is to create positive inflation, which includes asset price inflation.
• Asset inflation helps heal sick balance sheets and repairs a portion of the lost "wealth effect".
• When gold lies dormant, it means reflation is not working all that well in the minds of market participants. Gold’s recent breakout may indicate that the entire reflation of assets is working (in the minds of market participants - they fear future inflation caused by money printing, intervention, etc.).

Crude oil also can lend support to the relation case as market participants look for ways to protect purchasing power and profit from slowly improving fundamentals. Thurday's Energy Department report showed an unexpected decline in U.S. gasoline stockpiles, giving the bulls some fundamental backing for buying energy related commodities and stocks. Regardless of whether or not crude oil can hold the recent breakout as of the close Friday, the primary trend for oil will remain up.

As investors try to make sense out the of relentless bullish moves in asset prices, we will touch on a few timely topics:

• Is the Fed about to raise interest rates?
• What signal is gold possibly sending?
• Are bonds and gold telling us to sell stocks?
• Are stocks about to crash like 1987?

The Fed: Actions Speak Louder Than Words: Market participants better prepare for much jawboning from the Fed in the coming months. This from a October 9, 2009 Bloomberg story:

Common sense and prudence say stocks must experience a significant correction soon. Unfortunately, waiting for a correction to participate in the current stock rally has proved highly frustrating for many market participants. While it may not be what investors sitting on large cash positions want to hear, market history says a significant correction in stocks may not occur until 2010. Understanding and respecting that each individual needs to make their own decisions relative to market entry points, an open-minded review of the historical cases presented below may allow some to be more receptive to the possibility of bullish and correction-less outcomes for several more months. How things unfold in the coming months remains to be seen, but thus far the current rally has followed the new bull market script very closely.

Global stock markets remain in a state of positive fundamental and technical alignment. In this article, we will explore:

• Positive drivers for GDP and the end of the recession
• A historically significant turn in the S&P 500’s 200-day SMA
• Corrections within the context of a bull market

Improving Fundamentals

On Thursday, leading economic indicators (LEIs) posted their the fourth consecutive monthly gain. Global LEIs recently posted their biggest monthly gain since 1975. Going forward, low earnings expectations (relative to the prior year), which we have now, often result in positive earnings surprises as we leave a recession.

The transition from a bear market to a bull market is just that: a transition. Transitions take time and are not binary events like turning a light on or off. Transitions in any market can be frustrating and stressful, but if we continue to focus on the most important and telling indicators, the market should get us pointed in the right direction and aligned with the primary trends.

While there are numerous signs which can indicate the possible transition from a bear market to a bull market, the following two milestones are of uppermost importance:

The financial markets have done a good job of forecasting the slow improvements we have seen in the economic numbers in recent weeks. Even though the economy remains weak, we cannot ignore the steady stream of incremental improvements in the economic data.

For example, leading economic indicators (LEIs) have increased for three consecutive months. In the June report from the Conference Board , seven of the ten LEI components showed positive improvement. Since the lows in March of 2009, LEIs have risen 3.1%.

On Thursday, we had better than expected news in the form of the leading economic indicators (LEIs) and the Philadelphia Fed Index.

What the market did with the positive fundamental news could be telling for the short-term. We had gains on Thursday and Friday in the S&P 500, but it came on tepid volume and deteriorating breadth.

In 2009, the basic rationale for driving stock prices higher leans heavily on the 'less bad' perception of future economic activity. The markets, as evidenced by credit spreads, commodity prices, and stock prices, have been able to move away from “the end of the world as we know it” mode. An unprecedented amount of economic stimulus and newly printed money has helped shift the primary fear from one of deflation to a possible loss of purchasing power caused by deflation. The market’s perception seems to be “if things get worse economically, and they may, the policymakers’ response will be more stimulus and more printed money”. This perception coupled with the “less bad” outlook has increased the demand for inflation-friendly and weak-dollar assets (oil, gasoline, copper, emerging market stocks, foreign bonds, commodity-related currencies, etc.).

Since humans have been greedy and fearful since the beginning of time, they tend to act in similar ways before, during, and after a financial crisis. These tendencies manifested themselves during the tulip bulb craze of the 1600s, the dot-com craze of the 1990s, and the real estate mania of the 2000s.

Is the market’s recent strength, especially in commodities, telling us Friday’s employment report will be bullish (better than expected)? Recent data on employment this week support the possibility of a bullish number on Friday morning. But even if the employment numbers beat expectations, the good news may have already been baked into the cake.

As we prepare, it is always important to understand both the bullish and bearish case. The next step is to have game plans for both outcomes. Positive signals are coming from markets around the globe and from numerous asset classes. We all know the bearish case - we are overdue for a correction, financial crisis, etc. The bullish case is based on improving fundamentals and improving technicals. Chart gaps are part of a potentially bullish technical picture. Gaps exist above several markets - gaps that could be filled before or after a correction.

Before we get into the NASDAQ (QQQQ) recent new high and our possible approach to the markets, let's shed some light on Citigroup's earnings. Citigroup posted a $1.6 billion "profit" this morning, after a $2.5 billion "gain" because their bonds are worth less in the open market (you read that right, worth less). Note the use of the word "possibility" in the Bloomberg story:

Citigroup posted a $2.5 billion gain because of an accounting change adopted in 2007. Under the rule, companies are allowed to record any declines in the market value of their own debt as an unrealized gain. The rule reflects the possibility that a company could buy back its own debt at a discount, which under traditional accounting methods would result in a profit.

For those less familiar with technical analysis, markets often pause or reverse at their 200-day moving average, which can act as strong resistance.

Fundamentals – Stress Tests May Understate Where Unemployment Is Headed: Before we get into the technicals, on the fundamental side, the bank stress tests are obviously big for the markets. Since the government feels this is a “crisis of confidence”, you can bet the announcements will err on the side of building confidence. If they tell us everything is “ok”, does that really mean everything is “ok”? The baseline stress scenario and the more extreme scenario are not all that stressful – they most likely underestimate where employment and defaults are headed. The baseline scenario is quite optimistic with unemployment forecasted to peak at 8.7% - we are at 8.5% now (www.bls.gov). The more adverse and “stressful” scenario has unemployment peaking at 10.4% in Q4 of 2010, which is more realistic, but may not capture where unemployment peaks as we continue to move away from a leveraged world – with capacity to produce goods for a highly leveraged world. From a recent NYT article:

Rather than using hope as the primary driver for making decisions, investors would be well served to focus on the fundamental and technical facts. An analysis of the facts leads us to conclude we are facing the following in terms of probable outcomes:

• Highest Probability – New lows / continuation of bear market.
• Moderate Probability – Cyclical bull – higher highs – followed by retests or new lows.
• Lowest Probability – A sustainable bull market (secular).

Fundamentals Remain Weak: From November 1929 to July 1932, there were five rallies in stocks between 20% and 23%, and all were followed by lower lows. In the 2007-2009 bear market, banks have been the area of primary concern. Banks still remain a concern. While many market participants dismiss unemployment figures as lagging indicators, they fail to recognize that every time unemployment ticks up, default rates on all types of loans are going to tick up as well. The government has spent quite a bit of time and energy focusing on toxic assets in order to protect bank bondholders. The government’s programs will have a muted effect as long as housing prices continue to fall and unemployment continues to rise. The inventory of homes for sale remains very high. Home prices have further to fall until supply and demand come back into balance. As prices fall, the balance sheets of banks will deteriorate further. It is widely accepted that unemployment will rise further, which means default rates on loans will also continue to climb.

It is apparent many have jumped on the "a low is in" bandwagon in recent weeks. Given the environment we are operating in (a bear market), it makes sense for us to adopt a skeptical view of the "good" news that lifted stocks in recent weeks. The rally began after Citigroup's (C) talk of being "profitable" somehow found its way to the media on March 10, 2009. Below is a skeptical recap of some of the drivers of the impressive rally in stocks since the March 9, 2009 low.

The battle between current economic weakness and the Fed’s programs are playing out in the currency, commodity, and stock markets around the globe. Since history tells us stocks tend to bottom before the economy, we should remain open to all possible outcomes, bullish or bearish, even in the face of serious systemic problems. In Reflation: Déjà Vu All Over Again?, we commented that the S&P 500’s move through 806 sends a signal the markets are paying attention to all the Fed’s "liquidity facilities".

The Million Dollar Question: Are the current moves in commodities and stocks due solely to an aversion to currency debasement, or is the market also forecasting a better economy in the coming months? If the move is solely based on the Fed’s actions, then many of the current rallies may fail relatively soon. If markets are moving because of the Fed and an improved economic outlook, then we could be on the cusp of some bullish breakouts for numerous markets (see charts below).

It is possible we are experiencing a Yogi Berra (former Yankee catcher) moment reminiscent of his observation, "This is like déjà vu all over again." We all know the government is trying to reinflate asset prices with money printing, leverage, and bailouts. While stocks may not be out of the woods yet, yesterday’s move through 806 on the S&P 500 sends a signal the markets are paying attention to all the "liquidity facilities". Since all of the gains from the 2002-2007 bull market were fully retraced, you can make a simplistic argument the entire bull market (2002-2007) was largely based on easy credit and asset inflation. The fundamentals did not support a bottom in stocks in October of 2002, but the Fed was able to inflate asset prices with easy credit and leverage. Since the Fed is using a page from their 2002 playbook, we can reference 2002 to help us better understand the possible effectiveness of the current money printing extravaganza.

click to enlarge images

At some point during a bear market rally (we remain in a bear market until proven otherwise), market participants have to ask themselves, "Do I believe we have the fundamentals to support the recent move in stocks, oil, etc.?" Recent news continues to point to fundamental weakness, not a fundamental turn. Industrial production in Europe fell 17.3% from the year-earlier month, the largest decline since records have been kept (1986). A number like this does not point to a global recovery in progress.

Too Much Economic Slack: As the chart below shows, it is unrealistic to expect the economy to turn when we have capacity utilization numbers continuing to fall in the United States at an alarming rate. Excess capacity in a business is excess overhead, which cuts into profit margins. Excess capacity means even when we do see some improvement in the economy, businesses will have little pricing power for quite some time. It also means CEOs will have little need to spend money on any projects related to production, which in turn lowers demand for heavy equipment, materials, etc.

Even after the current "powerful rally", the S&P 500 is still down over 12% YTD, something to keep in mind if you feel we are missing something. All we have missed year-to-date is a 12% loss. Bear markets always give people a reason to stick around. Wednesday, we commented "...rather than signaling the end of the bear market, the more probable outcome for the current rally in the S&P 500 is for it to fail somewhere between current levels and 806." This rally may have further to run, but Wednesday's high on the S&P 500 was 803.

Fed Throws Gasoline on the Inflation/Deflation Fire: In our view, the most important fundamental factor in investing today is managing the shift from principal protection (as asset prices fall) to purchasing power protection (as the Fed eventually will produce positive inflation). As the average American’s 401(k) statement has shown in recent months, a principal protection strategy is more important than a purchasing power protection strategy. As cited by Wednesday's WSJ article below, The Fed threw gasoline on the inflation/deflation debate with Wednesday’s announcement. At some point in the future, purchasing power protection will be more important than principal protection – we are not there yet, but we have to pay close attention.