This Is Not How a Bull Ends

03/23/2010 12:00 pm EST

Focus: MARKETS

James Stack

President, Stack Financial Management

James Stack, president of Stack Financial Management and editor of InvesTech Research, says the market is not giving out any of the classic signs of being close to a top.

From the very beginning, we have called this the most “unloved” bull market in our memory. The wall of worry was extraordinarily steep, yet the market kept climbing.

In just 12 months, we’ve had five corrections of 5% to 10%. That’s more than the first year of any bull market since 1988—the year following the 1987 Crash. Then, as now, anxious investors were waiting for the other shoe to drop. It never did.

So, while this birthday week ushered in another round of fearful headlines, this bull market is still intact. In fact, it remains remarkably strong according to our technical gauges in both breadth and leadership.

Some are saying that investors are already too confident or bullish. To us, that is the furthest from the truth. And the AAII (American Association of Individual Investors) survey supports our position.

Most bull markets end with an overwhelming majority of investors in the bullish camp (usually two-thirds to three-fourths). And these AAII Sentiment extremes show roughly 60%-75% bullish consensus prior to the 1987, 2000, and 2007 market tops.

In the past 6 months, AAII bullish sentiment has never been above 50%, and [a recent] reading [was] only 36%. So, from a contrarian fundamental standpoint, this is not how a typical bull market ends.

Our Advance/Decline Divergence continues to hit new highs this month, even before the blue chip Dow Jones Industrial Average or Standard & Poor’s 500 index. This signals a broadening, not narrowing, of market participation or breadth. As one of the most common and earliest potential warning flags, this is not how a typical bull market ends.

There are certain divergences that commonly develop in an aging bull market, prior to the onset of a bear. Although each market top is unique, we have found negative divergences in the small-cap Russell 2000 Index or the Dow Jones Transportation Average to be the most valid warning flags. In other words, if the blue chip DJIA and S&P 500 Index hit new highs and the Transports or small-cap stocks are trailing far behind or heading downward, then it’s time to batten down a few safety hatches.

Fortunately (for us bulls that is), the Transports, Russell 2000, and Nasdaq [Composite] Index have all broken out to new bull market highs. In other words, these important indexes are leading the market higher—and not diverging negatively. Although the Dow is lagging, we suspect it will soon follow suit.

The bull market tops in 1990 and 2007 were more noticeable in negative divergence between the small caps and blue chips.  Both were classic warning flags. And all this, of course, is in sharp contrast to the performance of the Russell 2000 today. This is not how a typical bull market ends.

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