Patrick McGrady's  Instablog

Two questions that have been floating around the market recently are: 1.) When is the pullback in stocks going to occur?  And, 2.) How big of a pullback should be expected?  Market pundits and experts have been predicting a pullback of anywhere between 5% to 10% in stocks over the past few weeks.  However, this has yet to occur, as stocks continue to push higher.  We are getting to the point where hedge funds and institutions are actually afraid to sell-short stocks because of the recent bullish momentum.  It is usually at this point-in-time, when we get a slight correction because everyone who wants to be invested already is and with a lack of short-sellers in the market, there is nobody to take the other side of the trade (hence, profit taking outweighs buying and stock prices decline).  In a strong and momentum driven market like the one we are in today, we should not expect anything more then a slight correction because there are still a large number of under-invested market participants waiting on the sidelines anxiously ready to buy.  

As we examine a long-term chart of the S&P 500 SPDR (SPY), we can see the index has been range bound for the past 10 years.  The SPY's recent upward move starting in early '09 has been on very strong volume and momentum.  The index looks to be headed to the $155 level over the next two years.  On this presumption, pullbacks on the SPY should be bought until $155 is reached.  Over the short-term, a slight pullback of 5% to 10% should be expected, and it should be bought aggressively.  Right now the SPY is trading at the $132 level.  The expected 5% to 10% correction over the next few weeks should bring us back to the $120 to $125 level.  This pullback should present an excellent buying opportunity.  At $120 to $125, the SPY will have upside potential of 24% to 29%.  Fundamentally, the SPY is trading at approximately 13.8x forward earnings.  At our $155 two year projected price target, SPY would be trading for 16x forward earnings today.

The S&P 500 SPDR (SPY):
The long-term bullish momentum in the SPY has been confirmed by the long-term negative price action in the Volatility Index (VIX).  As you can see below, the VIX, which measures fear and volatility in the market place, has been trending lower since topping out in late '08.  Over the short-term, with rising commodity prices and economic uncertainty in Egypt, I would not be surprised to see a slight pop in-line with a 5% to 10% correction in the SPY.  However, over the next two years, the VIX will most likely trade lower to the $10 level, where it should find long-term support.

Volatility Index (VIX):

After consolidating for over a year, or all of 2010, European bank shares look ready to continue their 2009 upward momentum.  The foreign banks that look most attractive are the large ones, such as Deutsche Bank (DB), Credit Suisse (CS), and Barclays (BCS).  Deutsche Bank and Barclays are currently trading below their book value at 0.70.  Credit Suisse is trading slightly higher at 1.5 times book value.  Although, CS is trading at a slight premium, it is partly due to CS's low price-to-earnings growth ratio (PEG) of 1 and its 3.91% dividend yield.

The below table is a fundamental ratio analysis, which contains forward price targets for DB, BCS, and CS.



After looking at the fundamentals, we next need to look at the technicals or charts.  Below are the long-term technical charts for DB, BCS, and CS.  As you will see, since shooting up in 2009 on very high volume, the charts show the European bank stocks consolidating (trading slightly downward) all of 2010.  This consolidation is technically known as a bullish wedge formation.  A breakout above the bullish wedge's upper resistance line usually follows and confirms the bull trend.  In addition to the stock's price consolidation, the relative strength index (RSI) for DB, CS, and BCS has been consolidating right around the 50 line in what is technically known as a volatility wedge or squeeze.  This proves bullish because it confirms the stocks' price action.  Finally, as we look at the on-balance volume (OBV) indicator for DB, CS, and BCS, we can see a clear bullish divergence.  As the stock prices for DB, CS, and BCS pullback in consolidation, the OBV indicator stays well above its 2009 trough and its support line.  In comparison to the fundamental price targets for DB, CS, and BCS, listed above, the technical price targets seem to be in-line.

Deutsche Bank (DB):


Credit Suisse (CS):



Barclays (BCS):



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