Are you surprised the market is back in rally mode this week after last week’s stumble? It is pretty amazing, given how overbought the market is. Normally a dip like the ones we saw last week or in early March would jump-start some profit-taking by spooking nervous investors. One has to wonder if a wave of profit-taking is in the cards now because of last week’s trouble, but is just going to unfurl on a delayed-reaction basis.
On the other hand, stranger things can and have happened — there’s no specific reason stocks can’t keep advancing, unlikely as it seems.
And there’s the conundrum: common sense vs. the trend. The former says things shouldn’t go any higher, while the latter says stocks clearly are going higher.
While only time will really tell whether the market is too overbought for its own good, spotting a meltdown or a renewal of the bullish trend doesn’t have to be — and shouldn’t be — a matter of a gut feeling.
Here are the top three arguments from both sides of the table. If any of the technical ones are trumped, consider that a key clue as to what might be on the way.
The Bullish Case
Click to Enlarge1.) When it’s all said and done, even the 20-day moving average lines haven’t been violated. The 20-day average lines are the shortest-term meaningful moving average lines that traders keep tabs on. Although the S&P 500 briefly traded its 20-day average (blue) back in early March, the index was quick to crawl back above it, and it hasn’t even been tested as a floor since.
Click to Enlarge2.) The trend is your friend until proven otherwise. With or without the supporting evidence from the 20-day moving average line (or any moving average line, for that matter), stocks are pointed upward. As such, sheer inertia can keep the flames fanned as more and more investors pile into a rally that they have a growing amount of confidence in. Investors tend to keep things moving along within a well-defined bullish channel (orange).
3.) Though not “heroic” by any measure, the volume behind the rally has been solid — and getting better. Said another way, the pessimists who are saying there’s no participation in the rally are wrong, and becoming more and more wrong daily.
The Bearish Case
1.) The rally is getting uncomfortably long in the tooth. It’s now 73 days old and has left a 17% gain in its wake. For comparison, the average intermediate-term rally since late 2010 (a “normal” environment) has lasted 54 days, and has doled out an average of 15% during those periods. Translation: We’re overdue.
2.) The CBOE Volatility Index, or VIX, is right around 15 after a very prolonged pullback from highs near 43 in the fall of 2010. Though it’s still technically trending lower right now, the VIX also was technically trending lower in early 2010 and early 2011, too, when it reached the 15 area and kick-started a major pullback. The VIX might have reached a proven lower limit again, meaning the rally is running on borrowed time.
3.) We’re now at the point where year-over-year earnings growth starts to look lousy. Believe it or not, earnings don’t always grow at double-digit paces. Single-digit growth is the norm; we’ve just gotten used to huge growth numbers since we started to see growth again in 2009 because the comps were so very, very weak. How are traders going to react to the likely Q1 2012 earnings growth of 6.8% for the S&P 500 coming off of the 17% market rally spurred by Q4 2011 earnings growth of only 8.2%? One weak quarter can be a fluke, but two tepid quarters and clearly-high expectations (for more than single-digit growth) are a recipe for disaster.
It gets worse: Taking Apple (NASDAQ:AAPL) out of the equation for Q1 earnings means the S&P 500 is only on pace to increase income by 2.8%.
Both sides have good arguments, but obviously only one side can be “right.” The bulls seem to be winning the war by winning the day-to-day battles, but good traders know nothing lasts forever. Although stocks still are hanging in the balance, at least by understanding the arguments above, we can all proceed with a smart combination of strategic plans and contingency plans.
As of this writing, James Brumley did not hold a position in any of the aforementioned securities.