Stock Rally Defies Logic Only if Your Logic is Flawed. Here's Why Stocks are UpJun 05, 2012
The S&P is down 10% from its 2012 highs and Wall Street has turned deeply bearish. A variety of indicators – including technicals and a past parallel – suggest that a tradable rally is on the horizon.
“Stocks sink, pushing S&P to edge of bear market” - AP
“Recovery close to faltering, Fed could Act” – Reuters
“US investors can’t escape Europe’s prolonged debt crisis” – CNBC
Although it seems like those headlines came fresh off the printing press, they were actually published on October 3, 2011, right before the S&P started to rally.
Is today’s news bad enough to spur another stock rally? Some indicators do in fact suggest a looming bottom.
How reliable are those indicators and how strong could the rally be?
Different Year – Same Pattern
Market parallels come and go, but as long as they are present we may as well take advantage of them. Like in 2011, the ETF Profit Strategy Newsletter was expecting a market top and like in 2011, the Newsletter used a break below support as a sell signal.
In 2011 it was a break below 1,320, in 2012 it was a break below 1,386 (actual quote from the May 3, 2012 ETF Profit Strategy update: “A move below 1,386 will be a sell signal.”).
The red boxes in the chart below highlight the parallels that are of interest right now: August – October 2011 and May – June 2012.
The 2011 bottom came in the form of a deceptive double bottom, where the initial August 8 low was followed by the real low on October 4.
Based on various technical indicators the August and September 2011 ETF Profit Strategy updates consistently reiterated the need for another low followed by a major rally.
The October 2, 2011 ETF Profit Strategy update specifically outlined how a market bottom should come about: “The ideal market bottom would see the S&P dip below 1,088 intraday followed by a strong recovery and a close above 1,088.”
Repeat, Rhyme or Failure?
That’s exactly what happened last year, but does this mean that we’ll see another low somewhere around current prices? Let’s look at three important gauges:
Seasonality: Although June has a poor general track record from a seasonal point of view, election year Junes rank as the second best month for the S&P.
Sentiment: Investors are certainly more pessimistic than they were earlier in the year. The lower section of the above chart shows that the percentage of bullish advisors (polled by Investors Intelligence) is nearly as low as it was in October 2011.
Keep in mind that the S&P has only dropped as much as 145 points since its April 2 high. By October 2011 the S&P had fallen nearly 300 points or just over 20%.
Technicals: Like in 2011 the ETF Profit Strategy Newsletter has been expecting a low that slices below the May 18, 2012 reading of 1,292. This has now happened.
In fact, that new price low set up a few bullish indicator divergences, they are not huge, but the kind of divergences you should be seeing at a bottom. Those divergences can be seen in the chart of the S&P (SNP: ^GSPC), Nasdaq (Nasdaq: ^IXIC), and Russell 2000 (Chicago Options: ^RUT).
It would be careless to paint a purely bullish picture right now for two reasons:
1) Various studies suggest that if the market (NYSEArca: IWM) doesn’t find a bottom the bottom is likely to fall out.
2) The rally may not be as substantial as the rally from the 2011 lows and is likely to give way to the steepest decline in years.
Sunday’s ETF Profit Strategy Forecast for the week and month ahead outlined exactly how to recognize the market bottom and trade in a manner that maximizes profits and minimizes risks. It also includes the up side target for the upcoming rally.