A Fork in the Road for Stocks

05/18/2010 12:00 am EST

Focus: MARKETS

Mary Anne & Pamela Aden

Co-Editors, The Aden Forecast

Pamela and Mary Anne Aden, editors of the Aden Forecast, try to figure out the likelihood the markets will go in one of two directions.

It was a month that investors won’t soon forget. After hitting a 19-month high, the stock market turned volatile, reacting to one crisis after another. This reached a crescendo on May 6th, with the Dow Jones Industrial Average plunging nearly 1,000 points intraday, in its biggest drop in over 22 years—only to bounce again.

Even though concerns about Greece’s debt situation have been growing for a while now, the stock market was focusing on better earnings and the improving economy. But in the end, the news out of Greece kept getting worse. Contagion fears intensified, as well as concerns about the effect this could have on banks and the entire global recovery. These fears overshadowed any good economic news, and stocks fell steeply.

As the markets moved into panic and volatility mode it was hard to tell what might happen next, because it’s still too soon, but one of two options is most likely:

1.The stock market has been rising nearly non-stop since March 2009. During that time it has barely had a downward correction. The recent decline was likely the long-overdue correction within the bull market rise in stocks, which is normal.

If that proves to be the case, then stocks will continue to move higher and resume [their] bull market rise. The stronger economy tends to back up this scenario.

2. An intense financial shock could bring the global recovery to an abrupt halt. This is basically what happened in 2000, when the tech bubble burst, and again in 2007, when the subprime problems erupted upon the scene.

In this case, stocks would turn bearish [and] fall further. The first signs that’s happening would be a decline below the February lows and a break below the long-term moving averages (at 1010 on the Standard & Poor’s 500—Editor). This would trigger sell signals.

There’s also the possibility that 2000 marked the top in a mega-bull market that started in the mid-1970s. The stock market has essentially moved sideways since 2000. If the stock market is indeed correcting that huge 26-year bull market rise from 1974 to 2000, stocks could fall a lot further before they hit bottom.

In the 1980s, declining rates created a great environment for rising stocks. For now, interest rates are still low, and that’s good for stocks. In fact, rates could rise another point or two before rates could affect the stock market in a negative way. But when the time comes, rising rates will hurt the market.

On the bright side, [many] stocks are oversold and they’re now rebounding. This tells us to hold them, because they’re poised to rise further. If the bull market rise continues, we’ll keep them. If not, we’ll lighten up. 

If the markets stay bullish, for example, we may want to reduce our emerging market exposure. These markets have been much stronger than the US stock market. But they’ve been lagging in recent months and the Dow has been catching up.

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