The Financial Commentator: Update

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STOCKS

As I discussed in the Special Update on January 30, “Based on a number of momentum indicators, the market has reached an oversold level, comparable to readings at the July and November lows. Any additional weakness will get the market even more oversold, and stretched, laying the foundation for a rally. The odds favor the S&P bottoming above 1,030, and sometime in the coming week.” The S&P made a low on Friday February 5 at 1,044.50

I also discussed in the January 30 Update what it would take for the rally I expected to take hold. “Two pieces will have to fall into place for new highs. The overseas issues will have to settle down. China is not likely to make additional tightening steps in coming weeks, and the problems with Greece and the EU will also have to recede. And the economic data points in the U.S. must continue to support the recovery story. If so, large institutions will shift back to the buy side, after it becomes apparent the correction has run its course. A self sustaining recovery is far from a sure thing, but that doesn’t mean the illusion of one can’t be sustained for another 2 or 3 months.”

As noted in the February 22, 2010 letter, “The EU gave Greece 30 days to get their house in order, which has stabilized the Euro, and the majority of U.S. economic reports have supported the recovery story. The back bone of the rally since July has been a lack of selling pressure, rather than a surge in buying conviction. The low level of volume during this move up supports this conclusion. This isn’t the most healthy technical action, but as long as selling pressure remains at bay, the market can move higher. Although the upside is likely limited to modest new highs, any substantial market decline will be postponed until a secondary phase of the financial crisis erupts overseas, or institutional money managers are confronted with a series of economic reports that severely challenge their recovery thesis.”

Last week, the S&P made a modest new high (1,153.41 vs. 1,150.45 on 1/19/2010) on the back of a number of less than stellar economic reports that investors warmly embraced, and on exceptionally low volume. In five of the past ten trading sessions, total volume didn’t even reach 1 billion shares. The last time the 21 day average of total volume was this low was on August 29, 2008, which was followed by the explosion of the financial crisis in September. One has to go back to the summer of 2001 to find another example when total volume was so low, and that was just before the events of 9/11. However, the overall technical condition of the stock market is far different and far stronger than in those other instances of low volume. The advance/decline line is making new highs, while in 2001, the A/D line was neutral at best, and in 2008 it was very weak. In July and August of 2001, the 21 day average of stocks making new 52 week highs ran between +60 and +114. In 2008, it ranged between -469 and -72. It ended last week at +279. For the week of March 8, 2010, 898 stocks made new highs, with just 7 recording a new low. Although total volume is pathetically low, the market’s internal strength is quite healthy.

As I have noted repeatedly since last summer, large institutional money managers believe a sustainable recovery is developing. As long as they believe, they will not do much selling, other than to sell one sector to buy another. This lack of selling pressure has been an important factor, and has created a supply vacuum, allowing even a modest increase in buying pressure to move the market higher. Recent economic reports underscore just how much most economists and large institutional money managers believe in the recovery story. When only 36,000 jobs were lost in February, it was hailed as good news, since bad weather had lowered estimates to a loss of -65,000. BOO Yeah! And when same store sales rose over 4% from February 2009, it was like the second coming of Christmas! Never mind that comparisons to the first quarter of 2009 make everything look better, since anything looks up from the bottom of the abyss. The mentality of most economists and money managers reminds me of what happens about 30 minutes before the bar closes at 2 a.m. Suddenly, the joint is crowded with girls and guys who are looking fine!

The secular and cyclical headwinds facing the economy are substantial and suggest any transition to a sustainable recovery will not be smooth, and may even fail. The goal of the Federal Reserve and policy makers has been to buy time, in hopes that time and a ton of borrowed money will allow the economy to heal, and stabilize the deflating credit bubble. When your house is on fire, and the firemen rush to extinguish the blaze, who criticizes the firemen for water damage once the fire is out? The fact that a larger longer term problem is being created is secondary to keeping the game going now, especially with another election cycle coming in November.

If the economy does not produce the expected sustainable recovery, I think the technical action of the market will weaken before the fundamental economic news softens. Since most economists and money managers do not pay much attention to technical analysis, they will not see it coming. A softening in the economy would surprise the economists and money managers who have priced a recovery into the market, and lead to a rise in selling pressure. The market gave back 10 weeks of gains in two weeks, when selling pressure increased in late January, which might foreshadow the type of decline that could occur if the economy doesn’t deliver. The healthy technical condition of the market at this point suggests the day of reckoning is further down the road. Whether it is weeks or months, I don’t know.

The sharp break between January 19 and February 5 resulted in a swift pick up in negativity as measured by numerous sentiment surveys and the call/put ratio. The rally of the last few weeks has swept aside that caution. Most sentiment readings now show much more optimism. This suggests that the upside will be limited in the short run (1,160-1,180), and likely lead to a choppy period, until the overbought status of most technical indicators is worked off. Short term support should come in around 1,130. If sentiment remains bullish during this process, a larger correction would be set up, once the internal strength shows signs of weakening. The bottom line is: Sell into strength and become a bit more defensive.

Jim Welsh
jwelsh@welshmoneymanagement.com
760-436-3574

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