After 3 lackluster days of modest selling, the Bulls reasserted themselves yesterday. The markets’ strong up day was on moderate volume as advancers outnumbered decliners by a 3 to 1 ratio on the Nasdaq (NYSE was 2.5 to 1). That excellent breadth was accompanied by a strong up/down volume measure: For every 1 share that traded down on the Nasdaq, 6 shares traded up (1 to 5 on the NYSE). While these are not quite up to “breadth thrust” measurements, they are nonetheless very encouraging for the Bulls.
It is apparent that the markets are continuing to absorb the excess liquidity already pumped into the economy. Money supply (M2) may have tailed off and interest rates may eventually rise – but there is still plenty of fuel around.
Other issues, however, are starting to appear on the horizon that bear watching. Crude prices have been rising (see chart nearby), reflecting in part the increasing unrest in Iraq. The other issue on our radar screen is the relative valuations of stocks. Some analysts are arguing that U.S. stocks are no more expensive today, in value terms, then they were at the market lows. J.P. Morgan’s economists have observed “This year’s market rise has barely kept pace with profit gains, despite the implicit additional boost to stocks from the July tax reductions on dividends and capital gains.”
That is confusing cause and effect. Both stocks and earnings are up AFTER the fastest period of earnings growth has already occurred, and after most of the stimulus has already worked its way through the system. What’s more, mortgage demand has quietly slipped to a 15-month low. While these mechanisms – tax cuts and refis – carry forward some continued stimulative effect, the biggest impact has already been felt by the system. If the “pig is through the python,” are there enough catalysts to motivate stocks higher?
My answer is yes. Seasonality factors and momentum can take indexes higher into next year, but as the total impact of the stimuli starts to attenuate, expect growth to slow. That would make stocks start to appear pricier than they are at present by the middle of next year.
For now, traders should watch momentum and sentiment. Optimism has been excessive for some time, causing a degree of complacency to set in. Momentum has slipped from strong to “on pause.” But price action remains the most telling indicator we follow, and the price trend remains upwards. In our opinion, staying on that horse until the trend changes – even if it turns into a bucking bronco – is the way to wring the most upside from the rally.
Chart of the Week
A quick note about the Crude Chart referenced yesterday: It shows a pre-war run up to $38, the early war drop to the mid-20s, and the recent creep back towards resistance at $32.50. If resistance “gives,” oil could move to $34-36 per barrel, with potentially ominous overtones for equities.
Some of the oil price movement is in response to the Iraq situation, which has been deteriorating as of late. Expectations are for a strong U.S. response to insurgent attacks – if effective, that would have a placating effect on Crude prices, in my view.