The Stock Market’s Story

SPX – 1146.98

DJIA – 10,663

January 12, 2010

“If 2008 was the year of financial crisis and 2009 the year of healing via monetary and fiscal stimulus packages, then 2010 appears likely to be the year of ‘exit strategies,’ during which investors should consider economic fundamentals and asset markets that will soon be priced as a world less dominated by the government sectors.”

-Bill Gross, PIMCO January 2010 Investment Outlook

I let the stock market tell its own story and that story is uptrend. Against a negative media spin, troubled news backdrop, stocks continue to climb the proverbial “wall of worry.” The Market Trend Indicator (MTI), 21-day rule and 3-day swing charts all indicate uptrend and net volume readings remain in synch with the NYSE peak on this rally improving to +47.0 while NASDAQ stays at +48.4. The latest short-term rally is up six, mostly mild, trading days in a row and encouraging when grouped together and indicative of even higher prices. I was worried about weekly net volume, but it reconfirmed the cyclical bull market last week with a +22.9 reading versus (19.9) on the November pullback.

The MTI Uptrend remains in effect until one or more of the three key indexes closes below its respective 18% weekly exponential average. The SPX is well above its 18% average which stands at 1104.96 this week. The DJIA’s 18% average is 10,330 and the New York Advance/Decline line is 8,675 net advances above its 18% average.

The SPX is above the potential resistance levels mentioned over the past month (1134.19, 1136.35 and 1144.78). The next series (mostly based on geometric divisions of prior turning points) include 1150.20, 1158.76 (where the rally from July equals the first section up in price), 1166.88 and 1182.07. It’s the thirteenth swing for the SPX weekly swing charts (Late in the Move) so I’ve got my eyes open for a reversal, but the weekly momentum could carry the rally into the second half of February/early March with price targets between 1205 and 1230.

How far the rally carries and how long it lasts are unknown. I threw out a lot of numbers but definite forecasts leave investors and traders at the mercy of pride-of-opinion. If you stay open-minded and constantly question your position, you’re less likely to be surprised. In general, once you have an indication, the big money is made by taking a position early in the move and sitting, not by constantly trading. There’s a big difference between going long because prices “should be up” and because prices “are up.” It’s the difference between losses and profits.

Volume seems to reflect unwilling buying by under-invested pros at the margin, but except for a steady exit by small investors, there’s been even less selling. A rally can end with dullness but most end with a burst of volume and this advance’s persistent rise points towards the latter.

I’ve seen estimates that high-frequency and algorithmic trading accounts for about 40% or more of total volume. Speed counts in that world. BATS (Better Alternative Trading System) reported its U.S. trading platform lowered its average latency (time to make a trade) to 250 microseconds from 400 microsecond previously. There are one million microseconds in a second.

He’s long retired but I think Marty Zweig’s four main rules are all relevant today.

1. Don fight the Tape.

2. Don’t fight the Fed.

3. Beware of the crowd.

4. It’s OK to be wrong; it’s unforgiving to stay wrong.

From a Bespoke compilation, the average year-end SPX price target from thirteen mainstream strategists calls for a gain of nearly 10% in 2010 to 1225. All thirteen are forecasting higher year-end prices for the year, ranging from 1120 (Barry Knapp, Barclays) to 1325 (Binky Chadha, Deutsche Bank). Oppenheimer’s Brian Belski and JP Morgan’s Tom Lee have the second highest year-end target, 1300.

As we enter fourth quarter reporting season, data collected by Thomson Reuters shows S&P 500 profits are expected to increase 38% in the first quarter and 23% in the second quarter. As for group action, the top of the group relative strength list is AAA- Airlines, Automobiles and Aluminum (at least until Alcoa’s miss yesterday) with Steel and Coal rounding out the top five and paying off managers who bet on recovery. There’s still no evidence yet of the leaders pulling away from the pack.

Internet, Telecommunications and Computer Services sold off in a group rotation last week but I think their longer-term technical strength remains intact along with valuation, growth and balance sheet drivers. The bottom ten group relative strength list, is littered with Insurance (brokers, reinsurance & full line) along with defensive groups including Soft Drinks and Nondurable Household Products.

It’s been a liquidity-driven bull market, so let’s keep our eyes on the money. The Federal Reserve holds $909 billion of mortgage-backed securities, buying 73% of Fannie Mae and Freddie Mac sales in 2009. The Fed plans to top off its purchases at $1.25 trillion at the end of March. When it finishes, the housing market is likely to come under more pressure.

It’s been a liquidity-driven bull market, so let’s keep our eyes on the money. The Federal Reserve holds $909 billion of mortgage-backed securities, buying 73% of Fannie Mae and Freddie Mac sales in 2009. The Fed plans to top off its purchases at $1.25 trillion at the end of March. When it finishes, the housing market is likely to come under more pressure.

I suspect the bill for the bailout comes due later this year and the long-term government bond market is already sniffing this out. I haven’t figured out how to draw a trendline on a blog, but imagine a trendline connecting the lows in the weekly TLT chart where I thought the market could find support. Prices closed below it yesterday. Bill Gross told Bloomberg that PIMCO figures the end of quantitative easing by the Fed adds 30 basis points to government bond yields.

From Dow Theory Letters, the dollar lost about 95% of its purchasing power since the Fed came into existence in 1913. I still think the U.S. Dollar index could rally further in a counter-trend move. The pullback is normal is about 38% so far, not bad in the face of constant bad news.

Gold trades contrary to the dollar, a relationship I expect to hold. In my opinion, the technical picture for gold looks like it’s raring to go. Still, I’m keeping stops pretty loose (under the September 29 low or 989.50 2^nd London fix) at this stage as I don’t want to be stopped out of a long standing position before the crowd potentially goes mad with “gold fever.”

Back to stocks, here’s my list of high probability turning point or acceleration days

Harmonic Preview:

January 12       (Tuesday)

January 13          (Wednesday)

January 14          (Thursday)

January 20*       (Wednesday)

January 21*       (Thursday)

The total notational value for ETF trading volume was around $18.2 trillion in 2009 according to the ETFdb web site. Total ETF assets at year-end were $790 billion, up nearly 50% year-over-year. International funds took in more than $35 billion of new assets while investors to $8.5 billion out of domestic ETFs. Using beginning and ending asset values, the turnover ratio was 22.9 times. So much for “buy and hold.” The 15 largest ETFs were nearly 45% of the total assets, while more than 250 ETFs had less than $20 million of assets each. BlackRock, Charles Schwab and Pacific Investment Management entered the ETF management business last year and John Hancock, Goldman Sachs and T. Rowe Price filed with the SEC to join the party and launch new ETFs in 2010.

The stock market looks forward but I couldn’t resist a look backwards at the statistics that come early in the new year. For example, there were more than 1.4 million bankruptcy filings in 2009, up 32% but below the record 2.1 million filings in 2005 before the laws changed. Chapter 11 business bankruptcies rose 50% to more than 15,000.

Federal Highway Administration (FHA) data shows Americans drove 2.93 trillion miles in the twelve months ended October 2009, slightly less that the 2.941 trillion miles driven in the year-earlier period and the record 3.037 trillion miles two years earlier. Meanwhile, apartment vacancy levels reached 8% in the fourth quarter, the highest rate in 30 years. Office rents declined 9% in 2009 to $22.90 per square foot while the vacancy rate rose to 17%, the highest since 1994. New York City had the highest rents, $44.69 despite falling nearly 20% year-over-year but Washington DC closed the gap, down only 3% to $41.77 due to the employment trends depicted below.

The Hennessee Hedge Fund Index was up 24.6% in 2009, slightly underperforming the SPX’s 26.5% return. Hedge fund manager Jim Chanos was quoted in the New York Times saying he thinks China is heading for a crash due to credit excesses he deems “Dubai times 1,000 or worse.” Today’s Financial Times reports apartment prices in Japan are valued at 15-20 times average household income compared to 12-15 times in Japan at the peak of its real estate bubble a couple of decades ago.

Conclusion:

The trend is up and stick. Technical evidence indicates it’s late in the intermediate-term advance but weekly data turned more positive. A good defense enables the best offense. A close below the SPX’s rising trendline would be an early signal the rally is over. My recommended level for trailing stop sell orders tied to the SPX is just below the December 18 low (1093.38).

Once the trend reverses, I believe some of the best shorts are likely ETFs tied to cyclical groups or small cap indices. I know the rules call for shorting weak groups but given the contrary nature of the advance, investors are likely to seek safety in lagging, defensive groups so greater profits are more likely catching the turn in currently strong sectors.

For investors, it’s time to plan ahead as to what percentage of assets to hold in stocks once longer-term technical indicators show the cyclical bull market has run its course. I’ll keep you up to date on that front; it’s not even close yet. I think it’s best to hold higher-quality businesses. It also makes sense to raise cash if SPX prices surpass 1200 in the second half of February or later.

The information contained herein is based on sources that William Gibson deems to be reliable but is neither all-inclusive nor guaranteed for accuracy by Mr. Gibson and may be incomplete or condensed. The information and its opinions are subject to change without notice and are for general information only. Past performance is not a guide or guarantee of future performance. The information contained in this report may not be published, broadcast, rewritten or otherwise distributed without consent from William Gibson.