A Cautious, Reluctant Bull

03/26/2014 9:00 am EST

Focus: STOCKS

James Stack

President, Stack Financial Management

I hesitate to claim that Newton's Law—A body in motion will continue in motion, unless acted upon by an outside force—applies to the stock market; yet, in almost all our studies of past bear markets or crashes, there were causal factors that triggered the downturn, suggests Jim Stack in InvesTech Market Analyst.

Over the past 50 years, the most common trigger was a reversal or tightening in monetary policy. If you overlay a long-term graph of the 90-day T-bill yield, with the S&P 500 (SPX), this relationship becomes clearly visible.

One of the problems, however, is the variability in tightening, or interest rate increases, before trouble started in the stock market. Thus, the reason for watching as many reliable warning flags as possible.

It’s only natural that the size of last year’s gain would make one more nervous about the prospects for 2014. However, statistically speaking, the bearish odds did not increase simply because last year was a great year in the market.

Since 1928, there have been 18 years in which the S&P 500 increased over 25% (including 2013). Almost two-thirds of the subsequent years (61%) saw the market continue to rise the following year, with over twice as many double-digit gains as double-digit losses.

That doesn’t imply we should expect double-digit gains this year, yet it allows us to remain cautiously optimistic in the absence of bearish evidence.

In addition, breadth rebounded so sharply last month that it registered not one, but two new “breadth thrusts.” 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 four 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.

So, bottom line, we are encouraged about this bull market’s prospects over the balance of this year. With the margin debt and small-cap excesses described inside, I’m reluctant to speculate how long this bull market will last.

However, I don’t mind being a “cautious, reluctant bull,” as long as we’re prepared to quickly adjust our allocation level downward, if warning flags start to increase.

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