A Resilient Market Demands Your Attention

Markets worldwide have looked fatigued since mid-October. Some bourses have made marginal new highs and the American Dow has actually fared the best, posting its best November since the 1930’s. But leadership has thinned along with the new highs list and the markets have been susceptible to selling on bad news.

But if buyers can gain little traction neither can sellers. The Dubai default last week was tailor made to trigger a significant correction in tired indices that have achieved outsized gains, giving nervous investors an excuse to lock in gains. Markets around the globe scored significant losses on Thursday. The Shanghai Composite suffered two sessions of heavy losses in three days on huge volume, disturbing its resumed uptrend. And yet by Friday the selling had been arrested. And today it has been reversed.

Don’t let the fact that Dubai is a rather small place deceive you into thinking this incident was much ado about nothing. International crises have been triggered by seemingly minor incidents because of the mind set of investors. Clearly, even in a world where a subset of investors is sufficiently nerve wracked to invest money in 3 month T bills yielding 0% there is far more resolve in the minds of many investors than we may have given credit.

The market’s “rest” these last six weeks coupled with the reaction to the Dubai World default leads us to the conclusion that we are set up for a break out move higher, probably sooner than later.

Where do you look for investment ideas? We’ll try to cover some on our sister blog, but the market clearly favors three sectors that we have long suggested. Big cap stocks with plenty of international exposure. Commodity related stocks and their pick and shovel brethren. And BRIC stocks of all shapes and sizes, particularly of a Chinese flavor.

We continue to believe that China is heading for a significant hiccough, but we play the market that is in front of us. And the trends that have been in place since the uptrend began in March should continue to extend themselves for the duration.

A Catalyst

With its strained upside action the market has shown it is tired and only in need of an excuse to stage a significant sell off. Today it has one. The emirate of Dubai has threatened to default on its debt.

On the face of it this is a fairly mundane matter, an extension of the commercial real estate difficulties we have seen emerge throughout the developed world. But this is The Emirates, an emerging market that is supposed to be an engine ready to lead the developed world out of its morass. That it could be a part of the morass cannot inspire confidence.

Dubai is unlike other emirates. It has no oil and has relied on debt, mountains of it, to transform itself. The emirate has been in difficulty for months and on Wednesday the government there stopped reassuring debt holders and instead asked them to accept delayed repayment.

The prospects of contagion cannot be dismissed. Neither can the prospect of a significant American equity market sell off.

Although we do not know with any certainty we can imagine the scenario that led to these events. The overarching Emirates government probably wants a claim to pieces of Dubai’s mortgaged jewel properties in order to make them whole and Dubai is likely refusing, thus leading to their demand for a debt holiday. Ultimately we believe that the Emirates government and Dubai in particular will resolve this matter with a solution that will be grudgingly accepted by creditors, as the prospect of outright default and the lack of confidence it would cause would be mostly absorbed locally.

But in the larger perspective the notion that emerging markets are the new engine that will drive worldwide recovery should take a well deserved hit. Chinese markets have been rattled recently by the government’s plans to reign in the centrally authorized lending that has been the conduit for their domestic stimulus. It has been this stimulus that has been a major source of worldwide market enthusiasm this year. When combined with Dubai’s debt crisis, those pushing domestic equity markets higher after their impressive run will be forced to think twice about exposure at these levels given the lack of growth domestically and the prospect of vulnerability in overseas markets that have heretofore been the raison d’etre for the rally.

GDP Growth Augurs Poorly for a Robust Recovery

Q3 GDP Growth has been revised. Originally thought to be 3.5% it was reduced Tuesday morning to 2.8%.

This is dreadful.

We have emerged from a recession that might well have been the worst of the post World War 2 era. And growth is not much below trend, which is generally considered to be about 3.1%.

So why are we disappointed?

Because growth coming out of a recession tends to be like a stock exploding from a base as it embarks upon a fresh leg higher. Readings of 5%, 6% or higher for at least a couple quarters are not uncommon. Coming out of the recession on growth that is already below trend augurs poorly for the prospects of this recovery.

A good part of the performance could well be attributable to the ephemeral effects of the stimulus bill passed by Congress earlier this year. We might be registering positive GDP growth before we otherwise would and there exists the possibility that we could get a true break out quarter in the coming months.

But the economic tea leaves aren’t pointing in that direction. Instead we are left with a recovery far more fragile than we have seen in the past. While stocks have enjoyed quite a run in anticipation of recovery, at some point the market might well express its disappointment. We cannot say we haven’t been warned.

Small Caps Suggest a Period of Sideways Trade

A week ago we thought we had a tiger by the tail. Small caps, which had lagged the market badly, led a broad move higher. The 52 week high list looked as healthy as it had since the October market top. We posted numerous suggested plays on our sister blog. We positioned ourselves for another market leg higher.

But by the end of the week the S&P small cap 600 had given up all of Monday’s gains and then some. While the major market indices have recently made fresh 52 week highs the small and mid cap indices have not. And in spite of a furious rally again this morning small caps are clearly stuck in a trading range. Without their participation market upside is likely to continue to be restrained and limited to a narrow group of stocks.

There are plenty of examples of markets that have based with narrow leadership after a considerable run, only to move smartly higher when conditions allowed. The key is to not get chopped up in range bound trading, caught trying to position yourself for a larger move only to get repeatedly stopped out.

Money can clearly be made in a narrow group of large cap stocks. The market is favoring them at present because they are likely to have international exposure. With better growth overseas than domestically and a steadily sinking dollar that magnifies repatriated earnings, growth opportunities are likely to be better than with small caps, which tend to have limited resources and sell mostly in their home market.

More specifically mining stocks of various stripes are outperforming as they price in reaccelerating growth in Asia and Latin America. So are the “pick and shovel” companies so necessary to their operations.

And BRIC country stocks are faring well as the worldwide bull market continues to be led by these bourses. Capitalization doesn’t matter in this instance as participation is broad.

But chasing this small leadership group can be dangerous. Given the narrowness of selection they are obvious to the market and thus increasingly crowded with late arrivals that will prove to be weak hands at the first sign of trouble.

If you can catch these stocks on a pullback to their 10 or preferably 20 MA’s they might yield satisfactory swing results. Otherwise managing positions with substantial gains and sitting on cash could continue to be your wisest course of action.

We find the stock selection of a major growth mutual fund of no small renown to be revealing. The Fidelity Contra Fund, long a leading growth fund in spite of its massive size, has McDonald’s (MCD) as one of its top 10 holdings. This large cap international company clearly fits our profile of a stock that is attracting investment dollars in the current market.

We don’t mean to disparage the fund’s stock selection or the stock in question, but MCD has posted single digit year over year earnings growth this year on single digit revenue declines. Obviously the fund is counting on a resurgent domestic economy as well as continued international growth to ramp up earnings and sales ahead of expectations in the coming year. They are probably right in their assumptions and likely to make money in the position. Just the same, it’s telling when this is what passes for a growth situation in what we are coming to define as the “new normal.”

And it’s another reason to curb your enthusiasm.

Curb Your Enthusiasm

In July the rally was over. Everybody knew it. The S&P 500 had formed a bearish head and shoulders pattern on the daily chart and had fallen through the neck line. The March lows were up next.

And then it didn’t happen.

Instead we got a furious rally that extended 7% into new high ground on the NASDAQ and better than 6% on the S&P. For the first time market participants became convinced they were in a bull market.

Then in August the indices broke lower. But volume was light and bulls stepped in immediately to stanch the bleeding. The indices shortly broke to new highs. Investors were now confident of an enduring bull.

Just when investors were feeling invulnerable the market very quickly corrected again after making little progress into new high ground. But once again the indices found their footing and moved to new highs by 5% on the NASDAQ and nearly 4% on the S&P.

Almost routinely the correction in the second half of September was scooped up by investors. Yet this time the markets made even less headway into new high ground: just 1% on the NASDAQ and under 2% on the S&P.

October’s correction featured the NASDAQ undercutting a prior low, usually a late confirmation of a more significant correction set to unfold. But rather than succumb the indices again bounced back. This time the gains into new high ground were about ½% on the NASDAQ and 1% on the S&P.

And while the indices increasingly sputter on every move to new highs negative divergences abound. The narrowing of 52 week highs is our favorite, easy to gauge indicator. The breakdown of formerly leading stocks and cautionary signs given off by others is more subtle but cannot be ignored.

The latest casualty is Green Mountain Coffee Roasters (GMCR), a mid-cap that more than trebled during the bull market. It's fallen hard under its 50 MA, a key level for stocks in uptrends. Meantime Apple (AAPL) and Baidu (BIDU), two major institutional favorites of the rally, have potentially put in double tops that sport unfavorable volume profiles and appear vulnerable.

We still believe the markets will continue higher until the liquidity punchbowl is withdrawn by The Fed. According to the OECD in a release out this morning that might not be until late 2010.

But that doesn’t mean a more severe correction won’t be in the offing. The markets have avoided that to date and new bulls can go a year or more without a correction of 10% or greater. But we can hear the indices groan with every uptick each time they enter new high ground. Clearly the upside is limited for the moment. It might be time to take a step back and curb your enthusiasm.

Small Caps Reassert Themselves as the Bull Market “Re”-Broadens on Signs of Retail Strength

We have long preached to watch what people do, not what they say. Consumer confidence took a hit last month and that’s understandable. Unemployment is at a 26 year high. So when a surveyor asks a person whose employed how they feel about the state of affairs, but whose neighbor might be out of a job and who just got done hearing another report on how gloomy the economic environment is, that person is apt to say “just horrible.”

But according to Monday’s retail sales report that person is feeling good enough about their personal situation that they have ventured back into shops for clothing and household items and has resumed treating themselves to an occasional meal out. They’re not buying homes or furnishing them yet, but these purchases tend to come later in the recovery cycle.

This news sent the stock market to significant gains on a bump in volume. The major indices have now all broken to fresh recovery highs, but most importantly market participation broadened as small caps led the way with a gain of nearly 3% and the 52 week high list climbed back above 400.

What’s just as encouraging is renewed vigor in the Shanghai Composite, which led the rally worldwide from March through July before embarking upon a difficult correction. That has clearly concluded and the index has its August highs in sight.

Given the market’s performance today we’d again venture into smaller capitalization names, many of which have set up well in constructive bases capable of supporting fresh legs higher. Check out our sister blog for some suggestions.

All Roads Lead to Big Caps, Gold and Select Miners, and the BRICs

We reviewed a host of ETFs this weekend, hoping to find areas that are not yet apparent that could join the market’s thin leadership in a broadening rally should it occur. What we found is that there are no surprises at all.

We were shocked, for example, at how well a steel ETF is holding up given the poor posture of many steel stocks. But nearly 25% of the ETF is comprised of two iron ore stocks, Rio Tinto (RTP) and Vale (VALE). Iron ore is a key ingredient in the steelmaking process and these stocks are in strong uptrends, near 52 week highs. RTP is well situated to sell into China, and VALE is Brazilian. Another 10% is in Brazilian steelmakers CSN (SID) and Gerdau (GGB) and 6% in South Korean maker Posco (PKX), which is contiguous to China. Brazil and China, of course, are two of the BRIC markets leading the rally. Other than that there isn’t much happening in the world of steel, but the theme is clear, ore and BRIC companies or companies well placed to sell into BRIC markets. And, oh yes, they all happen to be Big Caps.

We looked at two retail ETFs and noticed a divergence between RTH and XRT. The former is at new highs while the latter has mounted a feeble rally attempt off its 50 MA. What’s the difference? The RTH is biased toward big caps retailers; It includes stocks at or near 52 week highs like Walgreen (WAG), Costco (COST), Gap (GPS.) and the parabolic Amazon (AMZN). The top 10 holdings account for over 80% of the fund. The top 10 holdings of RTH, which is packed with out of favor smaller cap companies, account for little more than 17%.

The tech ETF XLK is at new highs. Its 10 largest holdings account for over 60% of the ETF and include market leaders such as Apple (AAPL) and Google (GOOG). These two stocks have scored impressive gains since March and remain on the rampage. But it doesn’t hurt that stocks like Cisco (CSCO), Hewlett (HPQ), Microsoft (MSFT) and IBM (IBM) are included and are at or new 52 week highs.

Gold and gold miners speak for themselves. They have led since gold began its break out move in early September.

Only 119 stocks made fresh 52 week highs in Friday’s trading. That’s a sign the rally is mature and nearing its conclusion, but that doesn’t mean that the increasingly crowded new highs won’t go higher. Indeed, if the market doesn’t stage a broad sell off the parade of money into a decreasing number of stocks could well lead to impressive gains during the rally’s last days or weeks. It’s no accident that institutional money is finding its way into the most liquid stocks in the market.

We still recommend a cautious stance but can’t argue against joining the parade of money into big cap leaders, and we’ll post some suggestions on our sister blog. Many are not offering the kind of entry points that would make us comfortable for a multi-month hold. But as long as you are willing to keep a tighter reign during sell offs there exists the possibility of further gains to be had in a market that might not yet be ready to succumb.

Growing Negative Divergences Threaten the Market Uptrend

Stocks continue to bolt higher on earnings. AMZN was spectacular in late October, PCLN in early November. Just yesterday CTRP had a more modest gap to 52 week highs, but it was impressive nonetheless because the stock had run into the report.

So what’s the problem? Participation. There’s no volume in the market on up days. And on down days, like yesterday, it spikes higher.

That’s a sign that institutions, whose money is needed to move the market, aren’t so eager to commit. You should follow their lead.

After the market appeared to flout yet another more serious correction we posted a number of long ideas on our sister site. Most of them stopped out. As we’ve mentioned before, when technically sound ideas do not work it is because you are fighting the market’s true intentions.

There are stocks that continue to perform impressively. We mentioned a few earlier in this post. But their list is thinning. That’s another warning that shouldn’t be ignored.

The market can continue higher. The massive amount of liquidity floated by central banks worldwide has clearly led to a rise in all asset classes and continues to under gird the stock market. It might well continue to do so, but that doesn’t mean the market cannot abruptly correct.

We believe all but intraday traders need to be cautious in the absence of robust upside volume.

Liquidity Uber Alles

The stock market continues to move higher. Yesterday two important averages moved to fresh recovery highs. The NASDAQ 100 finished in new high ground while the S&P 500 marked a closing high.

As you might expect on a semi-holiday volume was light. But that continues a disturbing trend of an absence of participation on the part of institutional investors. A key argument for continuation has been that reluctant money managers who have doubted the rally’s staying power have to throw money at the market in order to stay competitive with their bogies. But if that were the case we should be seeing significantly higher volume as the Dow last week and now two other major indices move to fresh highs.

And speaking of highs, the 52 week highs list continues to be negatively divergent from the last trip into new high ground. Last month we saw nearly 700 52 week highs. Now, with all major indices save the NASDAQ in new high ground, that number is less than 300,

This speaks to the incredible levitating effect on the markets of Fed induced liquidity and the subsequent dollar carry trade. History teaches that without more significant participation the market is vulnerable to a sudden and ugly reversal, yet day after day the evidence on our screens defies that notion.

Antidote Needed for a Weak Tape

We’ve spoken about the positive resolution to the market’s crossroads, but market internals have been weak enough to cast lingering doubt on the uptrend.

Thus far only the Dow has made a fresh recovery high while the other indices lag. The number of 52 week highs is divergent with the last time an index saw new highs. And the entire move dating back to the beginning of last week has come on light volume, juxtaposed to the high levels of distribution we saw on the decline from the prior highs.

This is all fixable with an advance by the other major indices to fresh recovery highs. Indeed the S&P 500 futures have accomplished this feat in pre-market trading this morning.

The index will need to hold these levels to prevent yet another negative divergence. Worldwide central bank liquidity policies have sustained the market to this point, but central bankers cannot force the hand of institutional investors. Their resumed participation is critical. Without them the market remains in an unsettled position.

Resolution

In Take the Money and Run Woody Allen plays a man who is completely inept with women. His friend offers to set him up with a woman who wants only sex. The woman comes on to him in her apartment in very obvious fashion but when he makes a pass she slaps him, refusing his advance. The very next scene shows our hero descending the steps of his unrequited love’s apartment building exclaiming, “How could I have missed those signs.”

Very clearly we missed obvious signs in our piece yesterday. Last week we advised that The Fed statement insured that the market would resolve its correction to the upside. We honestly didn’t expect it would occur so quickly but clearly the G20 announcement that we discussed in yesterday’s entry did the trick. Light volume continued but it is very clear that stocks are just another asset class that is going higher because of the worldwide torrent of liquidity. With finance ministers from all over the globe reaffirming The Fed’s policy over the weekend buying should have been two fisted and on far higher volume. If there is a danger to stocks, it will not come from monetary policy anytime soon.

We had mentioned that we were prepared for the long side and posted some suggestions on our sister blog. The best performer of these, by far, was Apple (AAPL). The others were mid-caps that were higher but met with limited enthusiasm. The reason appears rather obvious to us. Big caps have international exposure and thus will benefit from a dollar that will not soon rally.

This is not to say that mid and small caps should be ignored. Of nearly 300 52 week highs on Monday 45% were midcaps and 38% small. But a check of the major markets shows the big cap indices making or closing in on new highs while the mid-cap index lags and the small cap lags even the mid-cap. But selectivity will be key in these arenas. Smaller companies will be far more beholden to the domestic economy.

Clearly commodity based stocks are leading the charge, but we think there are excellent opportunities that are not so extended in the medical, technology and retail space, and we’ll be posting them on our sister blog throughout the day.

Crossroads

The current correction across the major indices is in keeping with corrections we have seen throughout this year, which have measured from roughly 4 - 8%. Market participants could therefore not be faulted for expecting an upside resolution. In fact, a significant higher volume gain this week could end the correction and reestablish the uptrend.

There is an argument to be made for bull market continuation. Poor news last week, especially in Friday’s jobs report, only led to higher prices. Earnings season has gone well, although sales growth was not encouraging. And many leading stocks continue to hold up well in their uptrends. Several are breaking impressively to 52 week highs. Over the weekend the G20 essentially relented to Treasury Secretary Geithner in backing the continuation of stimulus measures and as we go to press weak dollar plays are flying and stock market futures indicate another attempt at market follow through is underway.

And yet the markets begin the new week at a crossroads. While we must be on guard for a bullish resolution the bulk of the evidence weighs in favor of a deepening correction.

We’ll focus on the NASDAQ in our analysis but our comments are equally applicable to the S&P 500.

A weekly chart of the NASDAQ shows a clear shift in volume patterns over the last seven weeks. Whereas earlier in the rally there was robust upside volume interspersed with lighter volume declines, of late the opposite is true, with the market selling off on heavy volume and bouncing on light volume. Last week was a case in point with impressive weekly gains marred by below average volume.

The daily shows us the development of a Head and Shoulders top. This pattern is most often successful when upside volume dries up as the pattern progresses. That is clearly the case so far.

A negative resolution might not occur immediately. There could yet be further upside in this oversold bounce in the market. But unless upside volume mars the pattern we could well end up with significantly lower prices later this month.

No Tea Leaves Needed to Parse This Fed

One of the most common parlor games in the business press is to muse about when The Fed will begin to remove monetary accommodation from the market. Or at least change the wording of the statement released after their meetings to signal to the market that a policy change is imminent. This page has long been of the opinion that the bull market will remain viable until this finally occurs. After today’s statement release it appears we are not close.

Lost on the public amidst the speculation is The Fed’s dual mandate, something we have been as guilty of overlooking as the next talking head. With the Humphrey Hawkins “full employment” bill in the late 1970’s The Fed was mandated to manage monetary policy not just with an eye to inflation but to employment as well.

This is why The Fed routinely appears late in removing monetary stimulus after recessions have clearly ended. Unemployment is a lagging indicator and the economy has long since been on the mend by the time it improves sufficiently for The Fed to begin raising interest rates.

We have not been alone in thinking that this time it must be different. The Fed has unleashed an extraordinary amount of stimulus into the system and we felt they would have to be timely in removing it lest it lead to an inflationary environment, violating their other policy charge.

But $80 oil and nominally record high gold prices seem to be insufficient to jar this Fed from their focus, which is to insure that sufficient stimulus remains in the system to ward off the deflationary effects which are normally the direct result of a financial calamity such as we endured in 2008.

The Fed’s resolve, which they have made abundantly clear in personal statements by various members for weeks, is an ongoing all clear sign to the carry trade to continue to bid the price of assets higher. While there must be some target prices for oil and gold that will force The Fed out of their somnolescence we are clearly not close.

The stock market is in a correction. And we believe lower prices are ahead in the near term. But The Fed has promised us today a second leg higher after this correction. You’d be foolish not to believe them. today’s statement release it appears we are not close.

Lost on the public amidst the speculation is The Fed’s dual mandate, something we have been as guilty of overlooking as the next talking head. With the Humphrey Hawkins “full employment” bill in the late 1970’s The Fed was mandated to manage monetary policy not just with an eye to inflation but to employment as well.

This is why The Fed routinely appears late in removing monetary stimulus after recessions have clearly ended. Unemployment is a lagging indicator and the economy has long since been on the mend by the time it improves sufficiently for The Fed to begin raising interest rates.

We have not been alone in thinking that this time it must be different. The Fed has unleashed an extraordinary amount of stimulus into the system and we felt they would have to be timely in removing it lest it lead to an inflationary environment, violating their other policy charge.

But $80 oil and nominally record high gold prices seem to be insufficient to jar this Fed from their focus, which is to insure that sufficient stimulus remains in the system to ward off the deflationary effects which are normally the direct result of a financial calamity such as we endured in 2008.

The Fed’s resolve, which they have made abundantly clear in personal statements by various members for weeks, is an ongoing all clear sign to the carry trade to continue to bid the price of assets higher. While there must be some target prices for oil and gold that will force The Fed out of their somnolescence we are clearly not close.

The stock market is in a correction. And we believe lower prices are ahead in the near term. But The Fed has promised us today a second leg higher after this correction. You’d be foolish not to believe them.

Economic Recovery Will Mitigate Damage in Commercial Real Estate

The national real estate virus wasn’t just residential in nature. It infected the commercial sector as well. There have not been as many dire headlines as residential has had because the commercial side peaked later and as such has not yet felt the full effects of the downturn. According to common wisdom it will shortly and this will raise the curtain on a second act of banking failures across the country.

As is our usual take on conventional wisdom, we doubt it.

We do not dispute that regional banks have significant exposure to the sector. Nor that many loans are under water and coming due, around $2 trillion by the end of 2010. Bank losses are projected as high as $300 billion in the next year yet they have made few provisions for write downs.

With vacancy rates approaching 20% many landlords are experiencing a cash crunch and struggling to stay current on their mortgages. And with real estate valuations having declined substantially from their peak many buildings will not qualify for refinancing.

In order to forestall damage to their balance sheets banks will likely take a short term approach and extend the loans when they come due. Over time this is an awful strategy and is a key to what led Japan to its “lost decade,” in which the government allowed the fiction that moribund loans on bank balance sheets were still performing. These so called “zombie banks” were so financially constrained they were unable to lend and in the absence of a healthy financial sector the economy stagnated for more than a decade.

Industry executives are in a panic. The Real Estate Roundtable is an industry group that would like a mortgage modification program similar to that which has been introduced to a certain degree on the residential side, where the government incentivises banks to write off some portion of mortgages they hold that are under water.

But in the face of all this talk of Armageddon came a report on Tuesday of a rebound in the sector. Prices rose 4.4% in the 3^rd quarter for the first gain in over a year and the largest in over two years. While one quarter doesn’t signal a trend it is notable that the number of transactions increased for the second quarter in a row. A bottom might well be in for the sector.

Further, MIT’s Center for Real Estate tracks supply and demand sentiment and their demand index moved 12% higher, marking the first gain in two years. The demand index reflects what potential buyers are willing to pay and it is now increasing.

These developments do not alleviate a clearly tenuous situation in commercial real estate (CRE). Prices could move higher for several quarters and would still be well below mortgage values on many properties. But in a world that has become convinced that the economy cannot improve without government intervention we have yet further evidence that economies heal on their own. And tentative signs of a bottom in CRE could well stem the most dire predictions of failure in the sector as the general recovery gains momentum, vacancy rates stabilize, landlord cash flow improves and the number of troubled properties begins to mitigate.

Expect a Surprise in Friday’s Jobs Report

Lately we’ve been discussing how even good news fails to drive the market. But Friday’s jobs report has the potential to catch the market completely off guard. Most market participants are expecting another dismal report and the unemployment rate to perhaps pass the long anticipated 10% threshold. But if Monday’s ISM report is any indication there may be a shock coming.

The manufacturing index posted its third consecutive reading over 50, which is the dividing line between expansion and contraction. The index was much stronger than expected, coming in at 55.7, the highest reading since well before the recession.

But of greater interest to us is the employment sub-index. It crossed the 50 threshold for the first time in over a year, posting a reading of 53.1. This is an early indication that the jobs report will not be as bad as feared, and in the current market environment “not as bad” could be a catalyst for a countertrend rally.

Of course there is the matter of a Fed meeting on Wednesday that has the potential to move the market as well, but if the market is oversold and looks ominous at the close on Thursday buying some calls ahead of Friday’s jobs report might yield a quick, low risk profit.

Cyclical Bull, Secular Bear

The title of today’s blog entry has become cliché but it holds true. We are in a lengthy period of “resting” in the stock market in which the indices consolidate the gains of the prior 18 year bull run. Markets sell off aggressively, base, rally aggressively and then repeat.

We have been in a secular bear market since the NASDAQ topped in March 2000. There have been cyclical bull periods during this time, most notably in 2003, 2006-7 and this year. But the indices have gone literally nowhere. This is the calling card of a secular bear market such as we had from 1966 – 1982 per the Dow chart shown below, reprinted with permission of Telechart.com.

Why do we bother to mention this? To remind readers that in spite of the exhilarating rally we have witnessed this year we are not in a period similar to the 1950’s or 1990’s. It would be a mistake to assume that the market will embark upon a constructive consolidation only to continue higher in a few months time. While the secular bear markets of 1929 - 1942 and 1966 - 1982 featured a number of second legs higher after strong bull moves there were even more instances of sharp rallies being followed by excruciating periods of choppy sideways trading or renewed sharp declines.

How then to gauge the current situation? For anyone but day traders it’s watch and wait. And there will be plenty to watch for this week.

We’ll be most interested in how the market responds to news. We recently reminded readers that in the current environment news will work in favor of the bears, as all but the best news will now be interpreted as bad. Witness the selling after the release of the GDP report last week. Rather than 3.5% growth being interpreted as a good sign all we could hear were reactions that this was stimulus engineered growth that would have no lasting power to drive the economy, and thus the markets, forward.

We will be watching to gauge the markets’ reactions to the ISM index today and the October jobs report on Friday. The market has been well warned to expect the unemployment rate to exceed 10% and it will be interesting to gauge the reaction if we finally cross that threshold.

We’ll also be interested to see how company and sector specific news pans out. Will animal spirits flow in the energy sector off Denbury’s (DNR) acquisition of Encore (EAC)? We have repeatedly discussed energy’s leadership role late in the recent bull market and covered it in depth on our sister blog as a sector that should be monitored for opportunity.

And will CIT’s bankruptcy filing further depress the financial sector?

Beyond all of this the FOMC will release a statement after their meeting on Wednesday. We have long been of the opinion that the bull market will not truly end until the Fed ends its easing policy. While they have clearly signaled that interest rates will remain unchanged the market’s reaction to any change in the course of quantitative easing will be telling.

On the negative side of the ledger is the retreat from risk that we are witnessing. This is most clearly illustrated by the failure on Friday of AEI’s IPO to price. We believe this was the most important story of the day but it received little coverage. It was just a few weeks prior that IPO’s were pricing well. Now they are being viewed with suspicion, especially private equity issues like AEI that are seen as little more than exit strategies ladled with debt with little appeal to new shareholders.

Finally we’ll continue to watch with interest the fate of Apple’s (AAPL) stock. Sorry if we sound like a broken record but this was the most liquid institutional leader of the rally and if cannot hold up we believe little else will.