'All Clear' Not Given For Stock Bulls Yet

Includes: DIA, EFA, MA, OEF, SPY, XLK
by: Chris Ciovacco

Despite significant evidence of a possible bullish turn in stocks, we also have evidence supporting a measured approach relative to what appears to be a bottoming process. We have presented numerous bullish developments over the last month:

  1. May 25: Bullish divergences
  2. May 28: Treasuries lose momentum
  3. May 29: Models show improvement
  4. June 6: Bullish divergences in play
  5. June 9: Bailout and technicals point to rally
  6. June 15: Central banks help break downtrend
  7. June 17: Signals lean bullish
  8. June 19: Breadth, models align with bottoming process

Since the first signs of a possible bottom on May 25, the S&P 500 gained 7.63% from the intraday low on June 4 to the intraday high on June 19. Despite the incremental investments we have made over the past few weeks, we still maintain a significant cash position. A fair question is why do you have so much cash if you have seen all these potentially bullish developments? A few reasons:

  1. Even if the S&P 500 (NYSEARCA:SPY) has made a significant bottom, bottoms tend to be a process as we demonstrate later in this article.
  2. As we described in detail in 2011, the problems in Europe are serious. We have noted recent reports of using bailout funds to possibly buy Spanish and Italian debt, which is potentially bullish for stocks. However, Europeans seem to favor summits and chatter over concrete actions. Markets know promises, visions, roadmaps, frameworks, and summits are little more than ways to kick the proverbial can down the European road. Like the markets, we want to see firm steps with detailed implementation plans.
  3. The Fed took the easy way out this week by announcing an extension of Operation Twist. Unlike pure quantitative easing, which adds printed money to the system, twisting is a bond swap made with the Fed's Primary Dealers. The Fed sells a bond and then uses the cash to buy another bond, which has little-to-no impact on the amount of money in the financial system. When you understand who gets the printed money in pure QE, it becomes more apparent how it helps pump up stock prices around the globe. Markets will interpret pure QE as bullish - another twist? not so much.
  4. Economic data has been weak recently. Thursday morning's Philadelphia Fed Index, a good leading indicator for the index of industrial production, came in below expectations.

The logic flow of one of our market models demonstrates the wide range of technical indicators we follow. One of the inputs for our models is the 50-day moving average (MA). The chart of the Dow (NYSEARCA:DIA) below shows a 50-day moving average that is attempting to turn up in a bullish manner. Numerous indicators and markets currently have a similar "we are trying to turn back up" look to them.

Moving back to the why do you still have so much cash question, the chart below shows the bottoming process in 2011. Notice the process included a nasty 10% correction in November.

Similarly, an 8% correction was part of the bottoming process in 2010. Our models are telling us a similar pullback is still a possibility even if a bottom is already in place.

Despite the noisy look of the table below, the concepts presented are easy to follow. Let's use the Relative Strength Index (RSI) as an example (last line in table). The chart below the table shows two intermediate peaks that occurred during the bottoms in 2010 and 2011 (points A and B in the chart). The table shows RSI hit 62 in 2010 and 65 in 2011 before stocks reversed and corrected significantly. The recent 2012 peak in RSI was 60, which is below both 62 and 65. The takeaway is as long as RSI remains below 65, then the odds of a significant pullback are meaningful. The odds of a significant pullback decrease if RSI exceeds 65. The same concepts can be applied to our market models. The table below has ten "all clear" thresholds for the current market to exceed. As of June 21, only four of the ten have been exceeded in a bullish manner. This tells us to remain cautious with our cash since a better entry point may be coming.

The chart below shows the periods in 2010 and 2011 when the S&P 500's 50-day moving average turned up in a bullish manner. Points A and A1 show the first tick up. The 50-day MA is shown in the top portion of the chart and the S&P 500 Index in the bottom portion. The S&P 500's performance to the left of points C and C3 show stocks experienced subsequent weakness (a correction) after A and A1 (where the 50 ticked up). The better entry points for investors came the second time the 50-day MA turned up (points B and B2). How does all this help us? If and when the 50-day moving average ticks up in a bullish manner, it tends to be indicative of a bottoming process, meaning we should be open to ongoing volatility, but also open to higher prices in the weeks that follow. It should be noted the S&P 500's current chart does not have a bullish, upward-sloping 50-day MA yet.

Based on what we know today, we believe any weakness in stock prices will be part of a bottoming process, and thus an opportunity to continue to incrementally reinvest cash. Given the fragile nature of Europe and recent weakness in economic data, flexibility remains extremely important. This is not a good time to be a permabull or permabear. The fundamentals (too much debt) are deflationary and bearish. The bailouts, money printing, and bond buying can spark strong bullish countertrend rallies. As we have seen in recent years, the market can go straight up or straight down depending on which forces are stronger. If the bottoming process continues, investors should be open to looking at Europe (NYSEARCA:EFA) during the next reflationary/bailout-induced rally. U.S. large caps (NYSEARCA:OEF) and tech stocks (NYSEARCA:XLK) are also attractive relative to other bullish options.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.