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How Far Can This Rally Go?

Nov 12, 2009
Simon Maierhofer

Back in March, no one believed in a major market rally. Eight months and 65% later, everyone believes the recession is over and higher prices are ahead. This article takes a look at the different stages of a rally and explains a behavior that is indicative of a disintegrating rally.

The fire keeps burning as long as there’s wood. The market keeps going up as long as there are sufficient buyers.

True as this statement is, it doesn’t help much when it comes to forming a strategy to profit from the market’s shenanigans. Here are a few tips that will:

De-couple yourself from emotions

There’s a time and place for emotions to roam free. Your spouse, kids, friends, family and even golf game deserve their fair share of emotions, money does not.

This is tough, because personal fortunes are linked to what your money does, or does not do. Successful investors, however, have an arm’s length, business type relationship with their own funds. This prevents them from getting caught up in frenzied buying or selling, which is almost always wrong.

Remember the last time everyone around you felt like they needed to sell stocks? Chances are this was right around March, when stocks approached their 10+ year lows. If you sold, as many did, chances are you ended up regretting this move. By now, you may or may not have jumped back into the market.

If you did, ask yourself: Why would you want to own any stock after it’s run up 30, 40, 50%, rather than holding or buying it when it was “cheap?” You guessed it -- emotions. Everyone was selling, so selling must have been the right thing to do – it wasn’t. Now everyone is buying, so buying must be the right thing to do – or is it?

From their March lows to their October/November highs, the S&P 500 (SNP: ^GSPC), Dow Jones (DJI: ^DJI), and Nasdaq (Nasdaq: ^IXIC) gained more than 65%. With every percentage point the market pushes higher, the risk of owning stocks increases. Here’s why.

The three stages – stage 1

Most commonly there are three stages to a major market advance. Stage 1 starts with the bounce from the preceding bottom and tends to be quite powerful. Stage 1 gains usually coincide with the extreme pessimism found at the previous bottom and that’s why most investors, aside from buy-and hold, miss out on the initial stages of a rally.

If recognized in time, however, stage 1 represents the biggest profit opportunity and highest risk/reward ratio. You could consider stage 1 the “low hanging” fruits of profits. On a risk adjusted basis, stage 1 gains are the most desirable as downside risk is lower than in any other stage of the rally because stocks are closest to their lowest point. Stage 1 rally profits were reaped starting with the March 9th low for the Dow Jones (NYSEArca: DIA), S&P 500 (NYSEArca: SPY), Nasdaq (Nasdaq: QQQQ), and other indexes.

Of course, those “low hanging profits” are only real profits if you didn’t get slaughtered by the prior decline. In December 2008, the ETF Profit Strategy Newsletter warned subscribers of an impending down-turn and recommended to use any reading above Dow 9,000 as a selling opportunity.

From January 2nd to January 6th, the Dow hovered above 9,000 before falling 30% over the next 30 days. After giving Dow 6,700 as a target range for a market bottom, the newsletter sent out a Trend Change Alert on March 2nd, predicting the onset of the biggest rally since the October 2007 all-time highs. The market delivered, and rich stage 1 gains were harvested.

The three stages – stage 2

The profits in stage 2 are often more limited as the gains of stage 1 are being digested. Sometimes the fear that the market has gone too far to fast, sets in. This brings uncertainty as to whether any declines will result in a retest of the prior lows. We saw such a “digestive period” from mid-March to mid-July.

The three stages – stage 3

Even though stage 3 is accompanied by the sentiment that the worst is over and a new bull market is at hand, the profits presented by stage 3 are less desirable. Money is money and profits are profits, so how can profits be less desirable?

Simply put, being invested throughout the tail-end of any rally increases the odds for lower prices exponentially. Asking the tough question, such as - How much more upside potential is there after a 65% monster rally? - can go a long way when it comes to protecting and growing your money. On a risk adjusted basis, stage 1 and stage 2 profits are much more attractive than stage 3 profits.

Stage 3 – how high can it go?

Theoretically, the sky is the limit and rallies can go on forever. How can one determine whether the up-trend is coming to an end? There is no magic formula, but there are a number of indicators that serve as effective red flags.

High beta indexes such as small caps (NYSEArca: IWM), technology (NYSEArca: XLK) and sectors that spearheaded prior declines/advances – such as financials (NYSEArca: XLF) and real estate (NYSEArca: IYR) - tend to take the lead throughout stages 1 and 2, but start showing signs of fatigue towards the later part of stage 3.

Just as these sectors lead the advance as long as the bull is strong, they start to lag when the bull tires. Monday (11-9-09) saw the Dow jump to new highs, while the S&P, Nasdaq, and Russell 1000 (NYSEArca: IWB) stayed behind.

This was corrected two days later, when the S&P, Nasdaq, and Russell also pushed to new highs. As of today, however, small cap and mid cap (NYSEArca: MDY) stocks failed to confirm this poke to new recovery highs.

This means that investor’s appetite for risk is waning. It is usually the later part of a stage 3 rally that investors are flocking towards large and safe (blue chip) companies, while withdrawing their funds from more speculative issues.

In addition to the behavior of the various sectors, there are resistance levels the market tends to respect. Such levels can be formed by either trend line channels or Fibonacci retracement, or a combination of both.

What happens after a stage 3 rally top?

Just as important as not getting surprised by a stage 3 rally top, is having an idea of what happens thereafter. Will the market merely trade sideways and digest the gains, correct and go on to new highs, or collapse like it did after the mother of all sucker rallies in 1930?

There is no shortage of indicators suggesting that the foregone conclusion of a ‘jobless recovery’ is not much more than wishful thinking.

If we block out the noise and go back to the basics, we’ll remember that tumbling real estate prices sent the mortgage portfolios of banks and lenders south. As long as real estate prices remain subdued, banks’ suffering balance sheets won’t see true relief.

The Associated Press just reported that third quarter median home prices fell in 123 out of 153 metropolitan areas over the past year, with a nationwide median decline of 11%. This can’t be good for banks. Perhaps that’s why the SPDR KBW Bank ETF (NYSEArca: KBE) and SPDR KBW Regional Bank ETF (NYSEArca: KRE) are still over 10% below their recovery highs.

Covered by a wet blanket

Rising stock prices have, thus far, covered up even major cracks in the foundation – such as unemployment and bank losses on their mortgage portfolios.

Ironically, it will probably be falling stock prices that will trigger the media’s renewed interest on what’s really going on.

Over the short-term, stocks are about to reach major resistance based on its own trend channel, Fibonacci resistance and historical parallels.

Over the long-term, stocks are still grossly overvalued. This will become all too obvious if you take a look at the levels P/E ratios, dividend yields, and mutual fund cash reserves have reached at major market tops.

The November issue of the ETF Profit Strategy Newsletter plots the historic performance of the stock market against P/E ratios, dividend yields, and two other trusted indicators, along with target levels for the ultimate market bottom and the top of this rally.

A picture paints a thousand words and those charts speak volumes about the market’s future. The fire keeps burning as long as there’s wood. Let’s enjoy the heat while we still have it, but be prepared for the cold. 

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