The Market Is At A Crossroads

Posted Fri Apr 03, 05:37 pm ETPosted By: Weekend Wisdom by Kevin Matras There are signs of both a potential market recovery (the beginning of a larger bull rally), and signs that this recent 20%+ run-up was nothing more than a bear market rally. The good news is that there will be plenty of opportunities going forward, regardless of which of the above scenarios plays out. Bull Market Rally Scenario The move that we have recently seen, i.e., 24.82% in the Dow Jones Industrial Average ($DJI), 26.82% in the S&P 500 (SPX), and 28.26% in the Nasdaq (COMP), from the lows made in early March to the highs made just 4 weeks later, suggests a larger move could be in store. For one, it's generally believed that a 20% rise in the stock market, marks the beginning of a bull market. Likewise, a -20% decline in the stock market, signals the start of a bear market. Secondly, the market had become terribly oversold (by Mar 6). You can see this on many technical oscillators such as the Relative Strength Index. (See the chart below.)

S&P 500 Index

It can also be quantified by the sheer number of new 52-week lows that were made in individual stocks while the market indexes were making new lows. In fact, each successive major new low made in the market (S&P 500: 839.80 on Mar 10, 2008, 741.02 on Nov 21, 2008 and 666.76 on Mar 6, 2009), brought with it fewer new individual 52-week lows each time, with the difference being in the thousands between the last lows in March 2009 and the 'first lows' in October 2008. This shows the market has either gotten ahead of itself or that perhaps too much value has been stripped out of the market. Either way, the market indexes are simply a composite of individual stocks. And if fewer and fewer stocks are able to make new lows, an upside test ultimately has to take place. Thirdly, the major indexes are all trading above their shorter-term moving averages (10- and 20-day) and medium-term moving average (50-day). This clearly shows the market's recent momentum has turned positive.

S&P 500 Index

And fourthly, on the fundamental front, there has been a steady stream of massive initiatives aimed at getting the financial sector and the broader economy moving again. The markets have reacted to these new developments, such as the second stimulus, the buying up of toxic assets and the purchase of US Treasuries. In addition, the Financial Accounting Standards Board (FASB) also made their long awaited decision on mark-to-market accounting for mortgage backed assets to something closer to "significant judgment" when valuing these assets. Combine this massive action from the U.S. with other significant steps taken from countries all around the world, and the market seems to be in a 'let's see if this will work' mode. Plus, recent earnings have come out better than expected on many companies (not necessarily stellar, but not as bad as feared) suggesting that maybe things have stopped getting worse, or at least the pace at which thing have been getting worse has slowed. Who knows if this is THE BOTTOM or just a bottom. If it is THE BOTTOM, then statistics show that a much larger move is in store. In fact, in a study of the Top 10 Worst Bear Markets since 1929 (using the Dow Jones), the average increase within one year of the lows was +55.62%. I don't want to get ahead of myself, but the 3-year increase is +77.56%. And the 5-year increase is +103.41%.

Dow Jones Industrial Average

Bear Market Rally Scenario The case for this being just a bear market rally, is just as compelling, and sadly, maybe even more so. But this does not mean it is and in fact, may even work against it being so.

First, let's address the 20%+ upswing we've seen in the market. While it's true, a bull market won't officially be called until there's been a 20% increase, not all 20% increases turn out to be bull markets. In fact, as the below chart illustrates, while the market was collapsing between 1929 and 1932, there were six 20%+ rallies that ultimately fizzled. And the market ultimately made new lows in 5 of those 6 instances. Of course, the 6th time turned out to be the charm, culminating in a 172.17% rise within the next 12 months.

Dow Jones Industrial Average

So while the 20% increase is a hopeful sign of life, it's far from being a done deal. This is already our second 20%+ rally (low to highs) within just the last six months. (Three, if you count the +24.25% jump within just 3 days in October 2008.) Aside from that, we saw a 22% rally between December 2008 and January 2009. In the current rally, we're up 24.82% so far. Of course the previous rallies failed, so we'll just have to wait and see.

Dow Jones Industrial Average- close as of Thursday, Apr 2, 2009

Second, while the market had recently been oversold, thus precipitating the rally, the oversold conditions have indeed been relieved, with conditions now reversing themselves and getting close to being potentially overbought. It's also ironic and worth pointing out, that even though the market has been charging higher, the last part of this rally (except for this past Thursday) has been made on declining volumes. Is the rally running out of buyers or believers already?

S&P 500 Index

- close as of Thursday, Apr 2, 2009

Note: the market's recent rally has bounced back to the underside of its bearish Descending Triangle that foreshadowed the recent downside breakout. And meaningful pullback from these levels could signal more downside to come. But an upside breakout would nullify this pattern's bearishness and remove a technical negative to the market. (See the chart below.)

S&P 500 Index

- close as of Thursday, Apr 2, 2009

There have also been some spectacular gains made in many individual stocks. Far greater than the averages reflect. And quite large for arguably one of the worst economic and business environments since the great depression.

This has led to an increase in valuations as well. The P/E ratio for the S&P 500 on Mar 6, 2009 when the last lows were made, was 11.16x 2009 estimates. Within a few short weeks, the P/E surged to 13.33. That's a 2.17-point increase or 19.44%. The run-up in the P/E ratio essentially mirrors the price increase without any real increase in projected earnings. Third, it's true the short-term moving averages (10-day and 20-day) and medium-term moving averages (50-day) are reading positive, but the longer-term moving average (the 200-day) is still negative (above the market and trending lower still). The bright spot is that it's quite a ways away from current levels. And since the 200-day moving average often acts as a long-term moving trendline (markets usually test and retest trendlines as the move up and down), a test of this important moving average, even if it gets turned away, could mean higher prices are still in the offing.

Dow Jones Industrial Average

- close as of Thursday, Apr 2, 2009

And fourth, while there has been a tremendous amount of action to get the banks and the economy rolling again, none of this is guaranteed to work. There have been some great ideas put forth. But sadly, there's a lot of politics involved and we have all seen how irresponsible some in Congress can be. This is important to note because the administration has said that it needs the private sector to be a partner in this. But the recent fiasco over bonuses from the first TARP funding, and the resulting hysterics that followed in Congress, has made the private sector very leery about 'doing business' with the government. This is evidenced by several big recipients of bailout funds, pledging to give it back as fast as they can to decouple themselves from the long and intrusive hand of the government. Conclusion So what does one do? There are clearly cases to be made for this being the beginning of a bull market rally or just another bear market rally. Whatever it turns out to be, there are plenty of opportunities to make money. For one, in October, when the market completely fell apart, it was almost impossible to make money on the long side of the market. The metaphor I like to use for that time is that it was like raining knives. Hard to not get hurt in that kind of market. But as we outlined earlier, each successive new low in the market witnessed fewer stocks making new lows, which shows that many stocks are starting to trade based on their own individual merits. This of course can be both good and bad. But it allows for the reward of individual stock analysis, and that's what we're all in the market for in the first place. To be rewarded for finding the right stocks to invest in and make money. And with billions of dollars of stimulus getting pumped into the economy, there will be plenty of winners in the months ahead. Focus on companies with the best Zacks Rank that also have real earnings growth, in the present year and in the future. Pay attention to the earnings estimate revisions, as they can be your first warning sign of trouble or good times ahead. I would also look at the technicals, especially chart patterns, as I believe they give clues as to when a stock will breakout and in what direction. Omniture, Inc. (OMTR) and Vertex Pharmaceuticals (VRTX) are 2 great examples and they are both stocks I picked for the Chart Patterns Trader service. Both of these stocks have just broken out: Omniture to the upside (we are long based on a bullish Inverted Head and Shoulders pattern) and Vertex to the downside (we are short based on a Bear Flag pattern). OMTR is a leading provider of online business optimization software, allowing customers to capture, store and analyze information from web sites and other sources, including social networking sites like Twitter for instance. This is an exciting company with dramatic increases in earnings projections. The numbers are small, but the projected gains are impressive. In 2008, OMTR posted 2 cents. In 2009, the company is projecting 12 cents. And in 2010, they're expecting 25 cents. Big growth, in a dynamic industry. VRTX discovers, develops and markets small molecule drugs that address major unmet needs. The company has several drug candidates in development including teleprevir, a drug for HCV infection, i.e., Hepatitus C, the most common form of liver disease. However, data from phase III trials for teleprevir won't be submitted to the FDA and the EU's EMEA until the second half of 2010 with the company then expecting approval in 2011 if all goes well. In the meantime, VRTX lost $3.25 per share in 2008. Is expected to lose $3.27 in 2009. And $3.07 in 2010. Hence our short position. Regardless of the market, there's opportunity no matter what and in either direction. Great Trading,Kevin Matras During today's crossroads market, Kevin and his team comb through hundreds of stock charts. No matter which way the market turns, they're finding companies poised to make sharp price moves. Certain chart patterns have proven to be uncanny predictors – with success rates up to 70%. Kevin's analysis indicates that something big is about to happen in the overall market. So Zacks is extending the special Chart Patterns Trader discount that had expired Friday. You now have until Monday, April 6, to take advantage of this substantial savings at a critical time. - close as of Thursday, Apr 2, 2009