Doubts Don’t Spell Doom

07/27/2011 1:30 pm EST

Focus: MARKETS

James Stack

President, Stack Financial Management

When doubts creep into the economy or market, it isn’t necessarily followed by doom, observes James Stack of InvesTech Research.

Wall Street remains on edge as bureaucrats continue their “debt-ceiling showdown” in the not-so-ok Washington corral. It’s hard to get away from negative headlines and scary television discussions—justified or not.

When fearful concerns surface, investors need to keep a close eye on the risks behind the debate, and what’s really important with respect to the outlook for the stock market.

Two of the most important warning flags to watch with respect to the US debt problem are the US Dollar Index and the 30-year bond yield. If investors perceived the risk of a default to be real, then the US dollar would plummet and 30-year yields would soar.

As yet, however, this is simply not happening. Over a four-month period earlier this year, the US Dollar Index fell 11%, and came dangerously close to the lows seen in 2008. Since then, the dollar has been stair-stepping higher, which has prompted experts to believe that this newfound strength might be here to stay.

When the Federal Reserve’s massive monetary stimulus (QE2) concluded at the end of June, expectations were for rising yields. To the contrary, and even in the face of US debt concerns, the long-term bond yields have in fact, moved downward. Additionally, this important bellwether remains well below the threshold level of 5%, seen just prior to the 2007 recession.

It’s not that we’re complacent with regard to the political showdown over mounting US debt. It’s just that we’re focusing on the objective facts rather than headlines and emotions. For now, the evidence suggests that investors shouldn’t overreact.

Market participation, as measured by the Advance-Decline (A/D) Line, recently hit a new all-time high. The A/D Line is the cumulative sum of daily advancing issues minus declining issues.

If we were heading into a bear market, it’s highly unlikely that the A/D Line would be diverging to the upside and leading the market higher.

In fact, breadth was so strong on the recent rally that on July 1, it registered another “breadth thrust.” A “breadth thrust” takes place when the ten-day total of advancing stocks outpaces declining stocks by a wide margin. This kind of upward momentum is often seen near the beginning of a new bull market, or at the start of a new bull market leg upward.

We found that since 1950, there have been only three instances when the S&P 500 was down more than 4% six months after a thrust was first observed. Also, there was only one double-digit loss (10%), which occurred during the 1973-74 bear market.

While this is a positive signal for the market outlook, it will be important for breadth to continue to hold up well in order to bring the current correction to a close. In the meantime, we’ll remain vigilant for any divergences or bearish warning flags that might emerge and require our attention. Stay tuned…

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