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Posted November 9, 2009

Topics: Global Business, Finance & Investing

Stock market trend: Likely market top reached

Last week, I called a market top; and the Dow Jones industrial average proceeded to reel off a 3.2% gain. There are a couple of important observations to make about this market action.
First, the tape never lies so it's important to be flexible when the market moves in the direction that you do not expect. While I entered last week slightly net short, I had a trailing stop loss on my major short position TWM and as the market rallied, I was able to close that short position and still preserve some my profits from the preceding week.
Second, the fact that the market rallied does not mean that I'm ready to give up on my call that a market top has been reached. As we enter this week, the Dow will open at 10,023. This is still slightly below the actual market top, which was registered at 10,092 on October 15. It will take a sustained push through this level for me to give up on my market top call.
In this regard, while it's interesting to note that the market rallied last week, the underlying technical indicators of the market continued to deteriorate. This passage from Market Edge is particularly telling:
Seldom is the case that the DJIA can muster much of a rally in the face of the numerous negatives that currently exist. In fact, the only thing that the market had going for it at the start of the week was that all of the major averages were in an oversold condition. The fact that there wasn't much improvement in the technicals last week makes the move suspect and probably unsustainable.
The list of negatives continues to grow suggesting that an across the board decline is still in the cards. The CTI remains negative at -04 as Cycles A, B & C are generating negative values. While a reset is projected to occur in the next couple of weeks, the current configuration typically results in a meaningful decline. The very weak Momentum Index indicates that all of the broader market indexes are down much more on a percentage basis than the DJIA, which is usually a precursor to a market decline. Also, as of the close on 10/30/09, all of the major averages with the exception of the DJIA, had closed below their 50-day moving average for the first time since July. This broad based weakness is also reflected in the number of stocks with a 'Long' Market Edge Opinion, which as of 11/05/09 has fallen to 1772, down from 3029 in late September 2009. Those with an 'Avoid Opinion' have increased to 1523 from 306 in September. Finally, volume on down days continues to outpace volume on up days, which is considered to be negative divergence and yet another bearish condition.
In considering whether a market top has been reached, it's useful to examine which economic indicators the market responded last week positively to. One important bright spot was a jump in the ISM Manufacturing Index. It jumped to 55, which is the highest reading since April of 2006. This was a sign that the ongoing investment-led recovery continues to gather some steam. Moreover, other countries around the world experienced similar improvements in their manufacturing indices.
A second indicator that the market responded to was a significant jump in productivity. Conventional wisdom here is that increases in productivity translate into higher profits and therefore into higher stock prices.
Equally important was the "dog that didn't bark." A rise in the unemployment rate to double digits didn't seem to faze the markets. It should be noted here, however, that the market probably should've reacted more to this number because that unemployment rate rose despite the fact that the labor force actually contracted. Moreover, the average work week remains at a record low, which means that the US labor force is significantly underemployed -- and therefore not generating as much purchasing power in the form of wages than it otherwise would.
Going forward, the same critical question remains: will consumers step forward and begin buying all the inventory that manufacturers are building on the shelves as part of this investment led recovery?  There was at least some optimism in the last retail sales report which was a bit stronger than usual. That said, these cautionary words from the Dismal Scientist website about that retail sales report suggests that the long-awaited consumer follow-through may fall short:
Sales growth excluding autos came in stronger than expected, and very few segments reported sales declines. This suggests that consumers are becoming more optimistic about economic conditions. That said, it is hard to see how this level of growth can be sustained. Wage income is not growing appreciably, although declines have ended. Wealth is substantially below its prior levels, although some of the pressure may have been removed by recent increases in equity and house prices. No further tax cuts or increases in government payments are legislated, although past actions continue to support disposable income. Asset income is still falling, although with the recession over, there are reasons to believe declines may be nearing an end. The bottom line, however, is that spending appears to be on a somewhat firmer footing than anticipated.
The other thing that was interesting to note last week was a sharp jump in the price of gold. The truly interesting aspect of this jump is the news that the Bank of India had sold a huge sum of dollars in exchange for bullion, essentially betting on a continued weakening of the dollar. It appears that other central banks around the world are likewise dumping dollars for goal; and this goes a long ways towards explaining why gold is in such a strong bullish uptrend.
The bigger message here, amidst all the talk about the euro or some other currency replacing the dollar as the world's reserve currency, is it may not turn out to be a currency after all that replaces the dollar. We may, in fact, go back to a de facto gold standard because there is no clear paper alternative to the US dollar. Betting long gold and short the dollar would seem to be a decent bet these days.
My bottom line for this week is that my call of a market top remains in play. However, last week's market action eroded some of the foundation for that call; and right now being either long or short the market seems to me to be more of a gamble than a speculation. Ergo, I am now completely in cash and will only get back in the market once the prevailing trend reveals itself one way or the other.
In closing, I found a kindred spirit quoted in this week's Barron's and I'd like to share with you that paragraph. These words are from Robert Prechter and he accurately captured the same strategy that I've been advocating in 2009:
While the stock market enjoyed a "bear-market rally" after extreme pessimism gripped the market in February, when Prechter says he advised clients to cover shorts and buy, that ended in October. Now, he suggests sticking with cash, as in short-term Treasury bills yielding fewer basis points than the fingers on your hand.
Yield can be the worst grounds for an investment decision, he assets. Prechter recalls that in 1981-82, when he argued equities could increase five-fold from the Dow's level of 800, the response was "how can you buy stocks with T-bills yielding 15%?" Now, he contends near-zero on safe cash is better than the chance of minus 40%.