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The Future of the Stock Market

After a super-strong January, the major indexes spent February consolidating their gains. Technically, the rally is still intact.

By Chloe Lutts

Editor of Dick Davis Digests


Stock Market Trend: Up or Down?

Two Arguments for More Upside

What Happened Last March?

After a super-strong January, the major indexes spent February consolidating their gains—with increasing volatility toward the end of the month. But even after the last week and a half, the major indexes all ended the month with slight gains; the S&P was up 1.11% for the month, the Dow 1.39% and the Nasdaq 0.56%.

Technically then, the rally is still intact. Unfortunately, that news is anything but reassuring to the hordes of advisors and investors who think the market is overbought, the rally overextended and sentiment overly optimistic. They would feel a lot better about this market if it would just go down for a while. Case in point is an advisor who sent out an email update Friday with the subject line: “Was yesterday finally the top for stocks?” He wrote in part: “Of late, it has been risky (and a losing proposition) to [bet against the market] based on what we think stocks should do in light of fundamentals, when traders with a lot more money (but less sense) are of a mind to keep chasing the market higher.”

He’s far from the only advisor today who thinks that stocks really should be going down.

The easiest counter to that assertion is our favorite Jesse Livermore saying: “Markets are never wrong; opinions are.” In other words, it’s what the market is doing that matters, not what you think it should do.

But, in the spirit of debate, I’ve also found several advisors making the argument that the market still has room to run here. In other words, they don’t think several months of gains mean the market should now go down.

The first argument comes from The Chartist Editor Dan Sullivan, who wrote recently:

“From our experience, bull markets invariably last a lot longer than the majority expect. The longer a bull market lasts, the greater its chances of prevailing. It is similar to insurance companies’ actuary tables in that the longer you live, the greater the odds are that your life span will be above average. ...

“We are now 31 trading sessions into the New Year with the S&P 500 posting an impressive 6.67% gain. This is quite similar to last year when the S&P was ahead 6.81% at the end of 31 trading sessions. For the entire year, it posted a gain of 13.41% without dividends. Similar to last year, many analysts feel that the market is overbought and has gotten ahead of itself. Some say it is ridiculously overbought.

“For a number of years, we have been using a 19-day exponential moving average of the Value Line Geometric to measure overbought/oversold (OB/OS) levels. A reading of +3.00 or higher is indicative of a heavily overbought market while +2.00 is mildly overbought. The current reading is 1.68, which is a neutral reading.

“The market was in a heavily overbought condition, +3.53, on January 2nd. The S&P 500 has gained an additional 4.03% in the interim. As you know, heavily overbought markets, which by definition are exhibiting strong momentum, seldom turn on a dime. In fact, the odds are strongly weighted in favor of additional gains.

“This was pointed out in our last letter: ‘Based on our experience over the years, we would expect the market to become even more overbought over the coming days. The OB/OS indicator is much more accurate in flagging market lows than highs. As an example, the indicator dropped to a heavily oversold -3.62 on November 14th which turned out to be one day prior to the lows of the selloff.’ Last year, the market reached heavily overbought status, +3.39, on January 19th. Then it proceeded to gain another 7.95% through April 2nd. The worst correction over the period, -2.24%, only lasted three trading sessions. It should be noted that just like this year, the S&P 500 posted gains of more than 4% in January: +4.36%.”

Speaking of last year, I recall writing a very similar article to this around the same time in 2012. It was called “Bull Markets Do Not Die from Old Age,” and you can read the whole article here. At the time (February 8, 2012), the S&P was up 7% since the beginning of the year, and 15% in five months. One of the analysts I quoted said “I’d feel quite a bit better about things if the market would just make a healthy pullback here.” Another said, “I don’t normally get bitten by the bear bug—but this market can’t keep up its current trajectory.”

The correction they were calling for did come, but not until April (and those nervous quotes were written in mid-to late January). Between February 1 and the end of March, the S&P tacked on another 7% gain. Yes, the correction came, but getting out of the market at the end of January, when another analyst wrote, “We think this winded bull, running since early July, needs to take a breather before he trips over his tongue,” would have left you sitting on your hands while the market continued to climb for another two whole months.

You would have done much better by listening to the second batch of analysts I quoted, who were reminding their subscribers that bull markets can last much longer than expected. They included Clif Droke, editor of Momentum Strategies Report, who wrote, “It’s only after everyone has become convinced that the bull market is here to stay ... that you have to worry about a major reversal of the uptrend,” and InvesTech Market Analyst Editor James Stack, from whom I got my title, “Bull Markets Do Not Die from Old Age.”

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I also quoted Elliott Gue, who looks prescient in retrospect for writing on January 16, 2012: “When the S&P 500 finally pulls back from its 52-week high, the move will be one of the most anticipated market corrections in recent memory. Practically every story about stocks these days, no matter how bullish, includes the caveat that the market is overdue a pullback. … It would be irresponsible to suggest that the broader market won’t pull back 5 to 10% at any time, but it would be even more irresponsible to claim that I can predict when such a retrenchment will occur. It’s possible the market will pull back in late January and touch its 50-day moving average of 1,235. However, it’s equally feasible that the market will surge beyond 1,300 before a meaningful correction sets in.”

Of course, the S&P then surged all the way to 1,400 before pulling back at all.

With that historical precedent in place, I’ll quote one more “contemporary” optimist. David Jennett, editor of The Investment Letter, takes a long-term view of the market trend in this analysis published February 4:

“As stock prices approach their all-time highs, now seems to be the ideal time to ask whether the stock price charts can tell us anything about the future of this bull move. Possibly, they might even tell us whether what we have been experiencing over the past few years is a new bull market or simply a rally within a long running secular bear market. Let’s start with the chart below. It’s the chart every bear keeps on his desk, and it’s the chart he shows to his friends or clients to prove that this rise in stock prices is soon going to result in a devastating collapse.

S&P 500 Chart 1

“The chart shows you what has been happening to the S&P 500 Index since the mid-1990s. Perhaps you have noticed how frequently this chart is used by those who are less than convinced that we have entered a new bull market.

“They are constantly reminding investors that they have nothing to show for holding stocks over the past 13 years. On the face of it, their argument seems pretty solid. Who could argue with a chart that is no higher today than it was 13 years ago?

“Well, as you may have guessed already, I can. I want you to look at another chart, the one below. This is the chart I keep on my desk, and it is the chart I pull out to show people why I believe that the bears are dead wrong when they say that we are heading for another epic crash in the stock market. My chart shows you the price action of the S&P 500 Index going all the way back to 1950. Because it covers so much ground, you must use a log scale rather than the linear scale you see used on the page one chart. The log scale allows us to track trends hidden when large moves take place over long periods. If you produced the page two chart with a linear scale, it would appear as if stocks barely moved for 40 years, climbed a bit from 1985 to 1995, and then ended with the massive rallies and equally massive declines from 1995 to today.

S&P 500 Chart 2

“I want you to pay particular attention to the trend line I have drawn on the chart. ... Note that the last bear market came about even though stocks were not all that far above the long-term trend line. It points to the difficulties of relying on charts alone to call market turns. The long-term trend chart can tell you when stocks are overpriced or underpriced, but it has little predictive value when it comes to saying just when stocks are going to revert to trend. The chart seemed to be saying that the market rally could have run on for a year or two more. Alas, so many problems came to a head back in 2008, the bull market was cut short; investors finally decided it was time for a knee-buckling correction that would rid Wall Street of the speculation that had come to define investing from 1995 to 2008.

“It was the purging of the speculative mentality that has me convinced that the rise in stock prices since March 2009 is real and has a lot further to go. ... In addition to having stocks still trading below the long-term trend line, we have earnings to consider. Prior to the Financial Panic of 2008, corporate earnings had begun to decline. After topping out during the second quarter of 2007, earnings dropped for nine straight quarters. That means that Wall Street watched earnings fall for more than a year before stock prices began to collapse. Today we have a very different story. Earnings have climbed for 12 straight quarters now and have surpassed the highs seen in 2007. Earnings for the last quarter continue to roll in and it appears they could be up 6%, good enough to make it 13 straight quarters of higher earnings. More importantly, confidence is high on the Street that 2013 will see a continuation of this streak. In fact, analysts are predicting that earnings growth will accelerate markedly during the second half of the year. When you combine rising earnings and the price chart that shows stocks have yet to regain the trend line that has marked this market’s path for more than 60 years, you get an undeniable feeling that 2013 is going to be a very good year for stocks.”

His prediction is obviously longer-term: it doesn’t help you figure out if the next correction is coming this month or next. But the message is the same: bull markets don’t die of old age.

What do you think? Is the market overbought and overextended, or are investors just overly worried? Have you taken your profits in anticipation of a big fall, or are you still making hay while the sun shines? Let me know by replying to this email.

Wishing you success in your investing and beyond,

Chloe Lutts
Editor of Dick Davis Digests

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Chloe Lutts Jensen is the third generation of the Lutts family to join the family business. Prior to joining Cabot, Chloe worked as a financial reporter covering fixed income markets at Debtwire, a division of the Financial Times, and at Institutional Investor. At Cabot, she is a contributor to Cabot Wealth Daily.