This Bull Market Has Legs

01/03/2011 1:09 pm EST


James Stack

President, Stack Financial Management

James Stack, editor of InvesTech Research, writes that abiding skepticism among investors is a great sign for stocks despite the Fed’s pointless meddling.

It’s healthy for the market to be nervous. It becomes unhealthy when complacency or speculation is rampant—and we certainly don’t believe Wall Street is nearing that point yet. There’s still too much doubt, nervousness, and distrust in the air, in spite of rising sentiment polls. [Stack explained in November why those polls are not the kiss of death for rallies—Editor.]

Overall, it was also healthy to have the sizable 16% correction this summer. That shook out a lot of nervous investors and created the climate in which any good news can only push the stock market higher. That’s where we are today—and based on the latest manufacturing and consumer confidence data, we see potential for ongoing favorable surprises in 2011.

The breakout in the blue chip indexes to new bull-market highs is easily surpassed by the strength in the economically sensitive Dow Jones Transportation Average. And the small-cap Russell 2000 Index, while the slowest to break out, was also the most decisive.

Sellers Burned Over and Over
It’s interesting to note that in the first 21 months, this bull market has experienced more 5% corrections than any bull market in decades. Corrections help keep the excesses—in sentiment and speculation—from developing.

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In addition, we are starting to see volatility settle down—another healthy sign. When looking at the number of large intraday advances or declines, volatility has dropped to the lowest level in three years. The graphic below shows the annual total of 1% daily moves (light shaded bars), as well as the 2% daily moves (dark shaded bars) in the Standard and Poor’s 500 index.

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Volatility typically peaks at bear market bottoms—as denoted by the arrow heads. It then subsides as the bull market matures, before increasing again in the next bear market. If history follows precedent, we expect 2011 to be less volatile than the gyrations of 2010, or the previous two years.

As we enter 2011, all technical and fundamental economic blocks appear in place for the bull market to continue, but it’s not too early to start watching for the monetary warning flags that could upset the Wall Street applecart.

Beware Fed Chairmen Bearing Gifts
In particular, we would have preferred it if Helicopter Ben (Bernanke) had called the Federal Reserve's bond purchases Titanic 2 instead of QE2. At least then, everyone would know that the movie ends badly.

No, we’re not saying the economy is going to hit an iceberg or sink. We just think it’s $600 billion being poured down a rat hole with a miscalculated purpose, bad timing, and little or no effect. [Axel Merk agrees, while many big investors have welcomed the Fed’s policy—Editor.]

In fact, after the first couple months of buying $75 billion (per month) in long-term Treasuries, the effect—if anything—has been opposite of the Fed’s noted desire. Instead of falling or holding steady, long-term Treasury yields are steadily rising. [Doug Fabian suggests profiting from the trend with a short-bonds ETF—Editor.]

One reason for this dichotomy, of course, is the disappearing fear of deflation as the economic recovery gains footing. It’s no different than coming out of the previous deflation scare in early 2009.

The question this time around is whether “bond vigilantes” are also starting to see a future inflation problem in the making. With commodity prices firm, and oil breaking out to a new two-year high, any surprises on the inflation front are likely to be to the upside.

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