Stock Market At Important Testing Phase

June 09, 2011

Has a market top already formed?

 

Last month, we made the case for taking a more defensive approach to the markets. Our reasoning was based on several factors:

1. The onset of negative seasonal trends (i.e., the “sell in May and go away” argument). There is a persistent historical tendency for stocks to generate most of their positive returns during the six-month period from

November 1 through April 30. Since 1950, the Dow has appreciated 7.4% on average during this favorable period, versus only a 0.4% average return in the May 1 through October 31 interval. The fact that the stock market was very strong in the six months ended April 30, 2011 (the Dow rose 13%) suggested that the stage could be set for this seasonal pattern to play out again this year.

2. The end of Fed money printing (which has been far more effective in stimulating financial markets than the real economy) and the renewed focus on the government debt crisis in the U.S. and Europe. We are now four weeks away from the end of “QE2,” the Fed’s misbegotten $600 billion debt monetization program. After this month, the Fed will no longer be injecting $75 billion per month of newly printed money into the financial system. Meanwhile, attention is back on the government debt crisis, and no progress has been made to fundamentally resolve the problem in the U.S. or Europe. It is not surprising that investors are turning more defensive.

 

3. A mature bull market with deteriorating risk/reward characteristics. After 26 months and nearly a 100% gain in the S&P 500, this bull market is mature by historical standards, both in terms of duration and magnitude. Last month, we stated that the stock market had quite possibly entered a phase where the remaining upside potential is smaller than the downside risk. In our estimation, this translates to perhaps 100 points of remaining upside in the S&P 500 versus 200 points of potential downside risk, which is not a favorable trade-off.

4. Growing inflation pressures and currency instability. $4 gasoline and the trade-weighted U.S. dollar flirting with all-time lows obviously is not a backdrop conducive to consumer or investor confidence. A break to new all- time lows in the U.S. dollar has the potential to be very destabilizing to global financial markets.

Recent market action has raised our level of concern that an important stock market top may be forming, or perhaps has already been made. The S&P 500 is less than 5% from its bull market high of 1370 of May 2, but we have seen: (1) two failed breakouts in April and May; (2) a well-defined downward trend over the past month (see Exhibit 1); (3) an obvious loss of momentum (the stock market has essentially gone nowhere in four months); and (4) a rotation toward defensive sectors such as health care, utilities and consumer staples.

 

Exhibit 1. A Close Below 1300 Implies a Retest of the March Lows

AI_06072011_001

 

 

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