The Next 6 Months

Given the rotation the market has been enduring lately, we thought it might be helpful to assess where the major indices are at present, looking out 2 quarters into the future. This is less an exercise in prediction making, and more an assessment of how the present market cycle might play out, based upon historical precedents.

Following a huge influx of cash at the start of the year – $40.8 billion in January alone – markets rallied until January 26. At that point, the Nasdaq peaked and reversed, while the Dow and the S&P formed a temporary top (See our January 22nd comments, “Market Flashes Yellow Caution Light“). They have not pulled back as aggressively as the Nasdaq did, and have stayed within striking distance of their 52-week highs. Indices such as the S&P SmallCap 600 Index (IJR) and the S&P MidCap 400 Index (IJH) continue making new 52 week highs, while their larger cap brethren have stalled.

The $40+ Billion dollar mutual fund inflow matched levels not seen since March 2000. A contrarian’s instincts should, at the very least, presume this surge of investor bullishness, coming at the tail end of a terrific rally, is an event likely setting a short-term top. Since then, the data suggests that inflows have dropped by over 50%. Comparing the present environment with the one from a year ago, we observe:

1) The market was very oversold then. Today, it is actually somewhat overbought; 2) Valuation was compelling a year ago; Now, there are far fewer “cheap” stocks; 3) Within the broader Market Cycle, equities were at a post-bubble lows in March 2003. After last year’s rally, we should expect a sideways consolidation for some period of time; 4) One year ago, economic data was at cycle lows. Recently, ISM data hit 20-year highs – and then rolled over.

These observations, however, do not suggest that the present rally is over. To the contrary, the Dow and S&P500 have yet to experience a 5% pullback. Until that happens, our working assumption is that we do not know when or where this rally will ultimately end. Historically, the first SPX/Dow pullback occurs halfway to two thirds of the way through the run – On average, at about the 60% point.

Until we experience an an initial retracement, our premise is that any pullback is part of a consolidation process, which could last up to 4 months. Once a 5% move occurs, we would expect at least one more leg up. If the first part of the rally scored 60% of the gains over a year, we would expect the remaining 40% move to take place over an 8 to 15 month time frame, complete with periodic spikes and sell offs.

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