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Up? Down? Sideways?

|Includes: SPDR S&P 500 Trust ETF (SPY)

Where are we headed? It can be extremely difficult to figure this out, especially when you throw in the element of human emotion. Perhaps the best approach is simply to use a mechanical system(s) that I profile frequently on Scott's Investments. From some of my favorite authors, whom I always enjoy reading even if I don't always follow their advice, some bearish/sideways/bullish cases. The bullish camp seems to be coming more from the technicals then fundamentals:

 

Conflicting reports from Investment Postcards from Cape Town:
 

Dow Theory Calls Bull Market: "The long-awaited Dow Theory bull market signal finally arrived yesterday. This came about as a result of the Dow Jones Industrial Average and the Dow Jones Transportation Average both breaking through their previous rally peaks (registered on 12 and 11 June respectively)."

Earnings -- Not What They Seem?: "While the earnings announcements thus far have been impressive at the headline level, the reports become less striking once one digs a bit deeper to discover that the earnings numbers often only beat estimates due to cost-cutting. And, at the top line revenues are still deflating, indicating no pricing power.

Chart of the Day provides some perspective on the current earnings environment by highlighting how 12-month 'as reported' earnings are expected (38% of S&P 500 companies have reported for Q2 2009) to have declined over 98% since peaking in Q3 2007. This makes it by far the largest decline on record (the data goes back to 1936). “In fact, real earnings have dropped to a record low and if current estimates hold, Q3 2009 will see the first 12-month period during which S&P 500 earnings are negative,' said Chart of the Day. This provides a sobering picture indeed, causing concern that in a number of instances a disparity is developing between stock prices and fundamental reality."


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David Rosenberg (pdf):


Well, the S&P 500 surged 15% in the second quarter and what we did was go back in the history books to see what happens to the economy the very next quarterly typically after such a big bounce and the answer is … just over 3% real GDP growth. So consider that de facto what is being discounted at this time for current quarter growth — it better be a humdinger of an inventory build. Now, for the market to build on such a rapid advance in the current quarter, history again suggests that we would need to see 5½% real GDP growth, which we give near-zero odds of occurring. Hence our call for a sputtering stock market through year-end. Too much growth — and hope — is priced in at this point.
THIS IS A PROFITS RECOVERY?

Over the past week, the expected YoY trend in S&P 500 corporate earnings has gone from -35.7% to -35.2% (see The Short View in Tuesday’s FT). Only 62% of the 100 S&P companies that have reported managed to beat their low-balled earnings estimates, which is hardly a stellar result. This is deserving of a 5% rally in just one week? To date, despite the hoopla over Goldman, Apple and Intel, this has been a highly uneven earnings reporting quarter. But the sharp comeback staged by Mr. Market just goes to show how desperate investors are for any good news they can get their hands on (we can’t say we blame them — it’s a critical part of the human condition to be optimistic).

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The Big Picture

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Although the U.S. equity market has had an impressive run since the July 7th lows, what many investors might find less-than-reassuring is how narrow the advance has been.

In the Nasdaq-100 index, for example, one stock, Apple, accounts for nearly one-fifth of the 11-percent gain. It has also pulled much more than its already hefty weight in the index. Otherwise, just nine stocks are responsible for more than half the move in the technology-laden bellwether.

While that doesn’t mean the rally can’t carry on, it’s another reason to be cautious on reading too much into the advance we’ve seen so far.

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The Disciplined Approach To Investing

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I continue to believe investors are in denial regarding the sustainability of this market advance and for good reason. Over 85% of S&P 500 stocks are trading above their 50 day moving average. As noted by the white circle near the top of the chart though, the market can continue to move higher while the percentage of stocks trading above their 50 day trends sideways.


As I have noted in earlier posts, the below chart was first publish in 1991 by technical analyst Justin Mamis in a book titled The Nature of Risk.


As the chart of the S&P 500 Index shows below, the resistance level is around S&P 1005. This was the level achieved in early November 2008 and corresponds to the market rebound from the panic phase in the above chart.


The caution is this analysis is strictly technical and the market could be topping out at the anxiety phase. Nonetheless, it appears we are past retesting the March lows.

Fundamentally, recent earnings reports have shown nearly 50% of companies reporting earnings have beat analyst estimates. This might not say much given analyst normally over estimate earnings at market tops and underestimate earnings at market bottoms. What if analyst under estimate earnings at the bottom of the market, maybe the second quarter does represent trough earnings. What is necessary now is top line revenue growth on a year over year basis.

Many companies have right sized their companies to operate at levels not seen since 2003 or 2004. Using one of these years as a reference point, then when will the year over year bar be low enough that top line revenue growth will show year over year growth? For some companies this positive year over year revenue growth bar could be realized in the 4th quarter this year and for others the first quarter of 2010. As the market tends to be a leading indicator, the market's recent advance may be telegraphing this potential scenario.

Individual investor sentiment continues to remain on the cautious side. The American Association of Individual Investors reported that bullish investor sentiment did increase to 37.60% versus last week's bullishness reading of 28.68%. However, the bull/bear spread remains at a negative 5%, an improvement from last week's spread of negative 18%. Prior market tops have occurred at spreads above 30%. Since the sentiment reading is a contrarian indicator and individual investors are not overly bullish, further market advances could be on the near term horizon.


A consolidation of recent gains is not out of the realm of possibilities. Retesting June support around 939 would be healthy and would equate to an approximately 4% market correction. Increasing market volume on positive market days could indicate the cash on the sidelines is finding its way into equities.

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See also

VIX/Futures Rare Situation