What Will Be the Signs That This Rally Is Ending?

04/27/2010 12:01 am EST


Michael Swanson

President, WallStreet Window

Before getting to the daily trends and what is now likely to unfold over the next few weeks, I think it is important to point out to you that the longer-term trend (one year +) for the stock market is strengthening. In fact, there is no end in sight for this bull market.

Yes, sentiment is getting frothy right now. The Investors Intelligence Survey is at an extreme level of the type seen this past January when the market made a temporary peak, and in October 2007, at the very end of the last bull market. However, you need more than extreme sentiment readings to call for the end of a bull market…or the start of one, for that matter.

Throughout 2008, there were more bears than bulls in this survey, and the market continued lower anyway, and in 2003, there were a huge number of bulls compared to bears in the survey, and the market went up for four more years. This survey is useful at times, but it isn't enough to make major calls on the stock market. It's more of a confirmation tool.

The VIX is also another popular indicator that people look at to gauge sentiment, but I've found it to be fairly useless to use in picking tops. It's more useful in picking bottoms, because the VIX is great at telling us there is panic in the market that tends to coincide with market bottoms.

The put/call ratio is showing a huge number of people buying calls over puts, but it's more of a short-term indicator.

In the end, there are two things most useful in telling what type of market you are in. The first is the relationship of the market averages to their 200-day moving averages. The second is market breadth, which people tend to measure using the advance/decline line.

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What people look for are divergences between the A/D line and the market averages to flash a warning sign that an end to a bull market may be near. In November and December, we saw a slight divergence, which led to a quick correction into February, but since then, the advance/decline has been making new highs along with the market, thereby telling us that this is a broad-based rally.

In the fall of 2007, one of the reasons we knew that the bull market was probably over was because the advance/decline line had been diverging from the market averages for almost the whole year. At the peak in October, most stocks and sectors were already in bear markets of their own when analyzed using stage analysis and looking at their 200-day moving averages. What happened is when the market made its final high, that move was driven by less than half a dozen tech stocks that were overweighting the market averages.

Incredibly, almost half of the sectors were below their 200-day moving averages at the time of the October 2007 stock market peak, with many of them well below them and in vicious bear markets. Mortgage, construction, and real estate stocks, for instance, had been falling for over a year and a half—almost straight down as the market made its final 2007 top.

I tell you all of this because right now, if you look beyond the market averages and the sectors themselves, you will see incredible strength. I use TC2000 to analyze the stock market, and it breaks the stock market up into 239 sectors. Out of those 239 sectors, I cannot find a single one that is in a bear market. Not one!

There are only four out of these 239 sectors that are even below their 200-day moving averages. They are long distance carriers, foreign utilities, telecom services, and farm products. And these four sectors are simply going sideways in a stage one base and look like they could just break out and go into bull markets over their own.

This is why I say there is no end in sight to the bull market.

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Now I'm not saying it is going to go up forever and isn't going to have setbacks. What I'm saying is that if you are a bear, there is no sign of light at the end of the bull tunnel when you look at the longer-term picture—I'm talking a year out—for the stock market.

Yes, eventually we will have another bear market. But before that happens, we will need to see dozens of sectors go below their 200-day moving averages and fall into bear markets of their own. Assuming this process was to start today, it would take a year for it to get advanced enough for us to worry about a new bear market starting for the major market averages and the entire stock market.

Forget about the Elliott Wave people who cite some magic numbers where they say the market must top out. One got a lot of TV time calling for a crash last October and was wrong. Forget about people's opinions about the economy, the deficit, and future problems that may hit us. The fact is this is a powerful bull market. Maybe those things will become problems later, but they are not problems now.

It looks to me like the stock market is going to go on for at least another year. Probably two years. And it will probably end with the market averages getting close to their 2007 highs. After that, we'd probably see another big bear market break out, but that's just guessing. It's predicting. All we can know for sure is the current trend of the market, and then invest accordingly until we see that trend change. That's how you make money, not by guessing what is going to happen or holding to rigid assumptions, but by recognizing what is really happening right now.

And with the strength of the market now, and the sectors inside it, that would take at least a year to happen.

Now the market is tough to buy into right now as a long-term investor. I advocate taking positions as an investor on pullbacks to the 50-, 150-, and 200-day moving averages on corrections within bull markets.

As we approached this April earnings season, I was telling you that the market was very overbought and it made no sense to buy into it. In fact, I warned you that almost every time the market rallied into earnings season, it has a pullback. I was expecting and hoping that we would see a pullback begin that would take the market down to at least its 50-day moving average.

At some point this year, I expect we'll see the market fall to its 150- and 200-day moving averages to bring about a great buy point for an investor, one on which they'd be able to safely buy and hold through the rest of this year and well into next year. That probably won't happen until the August-October time frame, however.

The reason why is because instead of peaking and going into a correction during this earnings season, the market has simply paused and consolidated to work off its overbought condition. Then on Friday, it closed at a new high for the year. That means that for now, the market is about to start another leg up. I have no idea if that will last for a few days or a few weeks, but it makes it so that it isn't likely for the market to start to drop right at this moment.

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I wrote an article a few days ago asking what would happen if the market didn't start a correction to its 50-day moving average right now as I was expecting. What might it do instead? I put this chart up in that article:

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In 2006, the market went just about straight up between August and February of 2007. During this time, it had a few quick and sudden pullbacks that were very shallow in nature and would only last a few days. We saw some similar type of trading in the summer and fall of last year too. Then, finally, in February, the market dipped back down to its longer-term moving averages and began one final rally.

The key is that fall rally in 2006. If the market doesn't suddenly top out, now it appears that we are going to see the market just continue higher in a similar fashion until it finally peaks out and corrects to its longer-term moving averages.

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The implications of this are clear—we will eventually get a good long-term buy point when the market comes back down to its longer-term moving averages sometime later this year. Until then though, it is likely to continue higher. If you don't buy into the rally and wait for a correction, then you will have a much safer entry point. You'll be able to buy and risk about nothing. But if you wait, you may miss out on further market gains for the next few months. Unfortunately, there is no way to know when the next pullback is going to occur. It could start tomorrow or a few months from now.

Until we get such a long-term buy point, I do not feel comfortable buying a huge basket of stocks myself, or recommending them as a means of timing the market, or buying just because the market is going up, because I prefer buying after market corrections.

By Mike Swanson of WallStreetWindow.com

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