Where Could We Be Wrong?

As Pinnacle investors know, we are investing defensively right now due to our feeling that the business cycle is under severe pressure and that technical conditions have broken down. Taking a negative view of the current situation is not a bad thing -- it is actually what we are paid to do when we feel it is necessary. However, given that we have a mission of beating our benchmarks over time, it is nerve racking to stay materially off the benchmark, because there's always a chance we are incorrect.

Here are a few examples regarding where we could be wrong in our forecast:

Technical Patterns: Some market patterns are tracing out higher lows and highs after the waterfall decline we have experienced. These are typically positive patterns.

Sentiment: Sentiment has gotten pretty bearish, which is typically a contrary sign.

Economic data: While we think the weight of the evidence we follow on the business cycle is negative, there are some data points that give us pause. As an example, the last ISM series was better than expected.

Analysts: There are some analysts we read who are warming up to the markets right here.

Europe: Now that folks are questioning a breakup of the Euro, perhaps it's time to bet on its survival? Maybe prior dysfunction in Europe is a catalyst for a major proposal that markets discount as a positive.

Emerging Markets: They are slowing, but perhaps they're poised to cut rates and increase stimulus.

High Impact Events: Maybe the Fed has another round of juice that moves markets, much like it did last time.

At the moment, we continue to give the downtrend the benefit of the doubt, and the weight of the evidence regarding the business cycle is still heavily skewed in that direction. Therefore we will stay defensive until evidence builds that better days are ahead. But the reality of forecasting is that there's always room for error, so in all environments we must question where we could be wrong in our thesis.

Testing Support

Stocks have had a rough go of it lately. The S&P 500 Index is off by about 7% from its most recent high reached on 4/29 due to a host of growing concerns, including an economic slowdown and the ongoing European debt problem.

The decline has carried the market down to its 200-day moving average, which it hasn’t really even been close to since last summer (shown on chart below). In addition, the S&P is also just above its 2011 low of 1,250 reached in mid-March. With stocks close to two important areas of support, and with signs of being oversold in the near-term, we believe that at the very least some sort of bounce should materialize soon.

We’ve been anticipating that 2011 could be a more volatile year, as the bull market passes its second anniversary. We’ve written several times that the most explosive gains are likely behind us, and that it would probably be much more of a grinding uptrend. While lately things seem to be moving in a more negative direction, we’re not yet ready to abandon the idea that the bull market may still have some life left in it. The vigor of a bounce, assuming one occurs soon, should provide some valuable clues as to whether the bull still has legs or if a more definitive market top may be forming.

Chart: S&P 500 Index w/ 200-day moving average

Another Little Sign

Is a bigger market sell-off coming? We are currently debating this question in our investment team meetings, and the answer is not entirely clear at the moment. However, there are technical signs that are starting to emerge which are unsettling to the bulls on the team. We have written before on the deterioration in the commodity markets and specifically the copper market which tends to lead stocks, and also the relative weakness in emerging market stocks. In addition, the relative outperformance of the non-cyclical sectors of the market which Carl wrote about last month has continued with increasing momentum. Finally, we have reached the season of selling as the old adage states that it's time to “Sell in May, and Go Away.”

Now a new, albeit smaller, sign has recently caught our eye. The chart below shows the percentage of stocks trading above their 200-day moving average (MA) on the NYSE. The 200-day MA is generally considered the long term average to determine the health of the stock market, and the chart is showing a couple of short term concerns. The first concern is that the amount of stocks over their 200-day MA was unable to break the February peak as the price of stock indexes broke out to new highs (called a bearish divergence). The second concern is that the number has broken below the March low, and now stands at a new 2011 low of 68% of stocks trading above their longer-term MAs.

The evidence still leans bullish overall as the long term trend is still healthy, momentum has not entered bearish territory, and most breadth indicators have not deteriorated. But more cracks are starting to appear. As a result we have started our sequencing process which Ken wrote about on Monday, and we will continue to monitor the health of the market in hope that the cracks will heal. But since hope is not an investment strategy, we will be prepared to act if necessary.

A New Cyclical High

On Tuesday, the S&P 500 closed at 1,347, besting its previous bull market high of 1,343 set on February 18th (shown on the chart below). The last two days have seen the market improve upon that, with successively higher closes on Wednesday and Thursday. Stocks are trading higher again today, too, with the S&P currently at 1,364. Considering that there were some high impact events this week with a heavy flow of corporate earnings reports, an important Federal Reserve meeting followed by a first-ever press conference held by the Chairman, and the first quarter GDP report, it has been another impressive display on the part of stock investors.

This week’s market action makes it increasingly appear that the sideways pattern of the past two and a half months, which included a -6.5% decline and subsequent rebound, was simply another consolidation in this bull market. All of the angst regarding the Middle East, Japan, and Europe seems to have only been able to muster enough negative energy to cause the market to momentarily pause again, instead of sending stocks spiraling into the abyss as widely feared.

Of course, things can change quickly, so we have to remain on our toes. Next week investors are sure to be bombarded by reminders that it’s time to “sell in May and go away” simply because the calendar has changed, which might create a new round of jitters. But our base case at the moment (subject to change based on incoming evidence) is that the S&P should ultimately be able to carry somewhere above 1,400 before the bull pulls in its horns for good.

Oil Falls, So Do Stocks

Today was a tough day for anyone holding risk assets. The combination of more rate increases in emerging markets, fears of Chinese growth faltering, Portugal’s debt getting downgraded, and more Middle East tensions had the markets rioting most of the day.

One interesting aspect today was that oil and stocks fell in unison for a change. Since the latest geopolitical tensions started, generally speaking, the trade has been oil up and stocks down, and vice versa. Why has this changed in the last two days? Well, one can only theorize. My guess is it has to do with what Sean wrote yesterday. The decline in copper may just be showing us that the rate hiking campaign along with higher gas prices are now siphoning off world growth. Perceptions change quickly, and overextended markets combined with ebbing global growth expectations might just shake some weak hands out of this market and create some value for those of us looking for a cheaper entry point.

Are We Finally Getting a Meaningful Correction?

For the past several weeks, we’ve been intending to boost risk exposures in our portfolios. In our view, the cyclical backdrop has been steadily improving (notwithstanding current geopolitical concerns), which should continue to be supportive of equities for the next few months, at least. However, given the market’s surge since late November, we’ve been patiently (some might say “wrongly”) waiting for a correction that would alleviate some of the growing bullishness in the market. As is often the case, the market has refused to cooperate for the most part as it keeps grinding higher, up until this week. The spreading turmoil in the Middle East has been driving commodity markets higher, which finally captured the stock market’s attention as oil prices breached the $100/barrel threshold.

Now, we find ourselves in a similar place as late January, when I last wrote an entry about a possible correction forming. Before today, the S&P 500 was down almost 3% from its recent closing high. Since the market has been routinely shaking off brief setbacks lately, we’ve been wondering, once again, if that was it.

According to data from Ned Davis Research, a 5% correction in the S&P 500 Index has historically occurred every 50 days, on average. In secular bear markets (which we believe we’re still in), they occur every 32 days on average. Through yesterday, it’s now been 126 days since the last 5% correction, which occurred last August when the S&P fell by 7%. In short, we’re “overdue.” But, back to that whole market not cooperating thing, there have been periods much longer than this between 5% corrections in the past, too. So while we have reason to believe the market is due for a deeper decline (despite today’s rebound), we need to be prepared for the fact that this market may continue its impressive (or, frustrating for waiting dip buyers like us) resilience.

Hussman’s Revenge?

Portfolio manager John Hussman has had a tough year in his growth fund (which is a holding in three of our investment strategies), as his very cautious forecast has led him to maintain a very defensive posture by hedging his equity exposure despite a rapidly rising market. For months, he’s argued that the market is facing a specific set of conditions (overvalued, overbought, overbullish, with yields rising) that historically have preceded abrupt market declines that can knock out months worth of gains in a very quick burst before clearing and becoming safer for investors.

Yesterday’s decline on increasing geopolitical risk in the Middle East has quickly wiped out all the gains since the first week in February. It’s only one day, I know. But after months of a relentless climb, I wonder if the markets are in the midst of being “Hussman’d.”

Chart: S&P 500 Index

Clash of the Technical Titans

One of the dynamics within our investment team is that people have their views, and they will not always be in harmony. This is a good thing, and balances our team, but at times it makes for difficult discussions and decisions. Currently the team is somewhat divided regarding how aggressively to position portfolios at this time. What’s interesting is that we share the same view of higher markets over the next few quarters, but the shorter term timing currently has us divided. The crux of the current disagreement rests on which technical measures matter more right now.

We have one technical camp that thinks we need to be positioned more aggressively here. They reason that massive liquidity, great seasonal tendencies, excellent trends, and solid momentum have created a solid wave that we should ride while the sweet spot exists. I’ll admit that I haven’t been in this camp, and that this camp has been winning the battle this year. I tip my cap to those in the group who have been aligned with this view.

The other side of the technical coin, and the one I have currently embraced despite its short term pain, goes something like this: market sentiment is showing extreme levels of complacency, mild divergences have been forming, markets participation has been narrowing, trends are very overextended, and the more the market ignores this and continues up, the more susceptible it is to a painful reversion to the mean on the next correction when the rubber band ultimately snaps back. On a snap back some froth will clear and weak hands will shake out, and that will be a better time to get more aggressive. That hasn’t worked out thus far, but I’m not ready to abandon this view yet.

I imagine we’ll continue to have interesting and difficult discussions as this Clash of the Technical Titans sorts itself out over the next few months.

Trend…Counter Trend

I am reminded of the classic Saturday Night Live skits where Dan Aykroyd and Jane Curtain faced off in their news update, Point/Counterpoint. Jane would take one side of an issue and then Dan would start off his comments with the famous words, “Jane, you ignorant slut.” Delivering all of this with a straight face was the perfect parody of weekend television anchors opining on various topics of the day. So, in this blog, I present Trend, Counter Trend, where it becomes clear that the current investment environment is….unclear.

Trend: The S&P 500 Index has doubled in value from its March 2009 low. The market is overbought and its time to take your profits and run.

Counter trend: Forget the usual metrics. Based on forward earnings the market is still cheap. Value investors who get out too early are going to get crushed as momentum carries the markets all the way back to their 2007 highs.

Trend: Emerging economies around the world have taken a drubbing recently. Everyone is screaming about reducing allocations to emerging markets and rotating to the U.S. If you haven’t sold you haven’t been paying attention.

Counter trend: China is battling a property bubble and food inflation with tighter interest rate policy. The property bubble is exaggerated and the food inflation is a short-term problem. Buy the dip. This is the buying opportunity of a lifetime.

Trend: Commodity prices, especially food commodities like wheat, soybeans, and corn, have been skyrocketing. With this year’s unusual weather limiting global food supplies, expect even higher prices to come.

Counter trend: Food inflation is transitory. Most of the supply issues are already in the price. Now that commodity inflation is making headlines, it’s time to sell. Get out of commodities now.

Trend: Everyone knows that interest rates have to go significantly higher. Bond vigilantes are going to ignore Ben Bernanke and move rates higher with him or without him. Higher rates are a headwind for the current stock market rally.

Counter trend: Bonds are cheap. If rates get back to 4% on the 10-year Treasury you should back up the truck and buy. The U.S. financial system is still a mess as is evidenced by the broken money multiplier. There is too much slack in the U.S. economy to be bearish on bonds.

I wonder how Dan and Jane would have delivered this material. We actually have these discussions every day in the investment team. Now that I think of it, it really doesn’t get a lot of laughs.

Sell the News?

Today brought the release of 4th quarter GDP, which came in at 3.2%. The headline number was below expectations for 3.5% growth, but let’s not get crazy here, as this number was pretty close, and will be revised two more times before it becomes official. Within the report, personal consumption was a notable positive, and it exceeded expectations with a 4.4% gain versus the estimate of 4%. I don’t think anyone around these parts will take issue with GDP in the 3% range, since that should be strong enough to help the labor market marginally improve, while not so strong that it would cause the Federal Reserve to consider tightening monetary policy.

But what is Mr. Market doing on this number? Well, it’s selling off handily at the moment. One thing to remember when assessing these GDP reports is that the data is clearly looking in the rearview mirror. We have been encouraged with the state of the U.S. economy in recent months, and we’re not expecting a sudden change for the worse over the next few quarters. But we have also been worried about the complacency building in markets. Lately the U.S. stock market has continued to rally, but we’re noticing potential warning signs coming in the form of technical divergences and the recent poor relative performance of a number of risk assets versus the broad market (small caps vs. large caps, emerging markets vs. U.S., silver/gold ratio, etc).

The monetary policy differences in China (raising rates) also create the potential for slower exports (which happens to be a big positive contributor in today’s GDP) on the back of slower international growth. Often times markets buy the rumor and sell the news. I wonder if this GDP number doesn’t represent a typical “sell the news” event. If so, a healthy correction in stocks would not only clear some of the weak hands in the market, but could set up a healthier environment to reposition for the possibility of another move higher in this bull market.

Was That It?

We’ve been anticipating a correction in the stock market for a couple of weeks, mostly due to signs that the market is overbought and investors have become too bullish in the short-term. Over the past two days, it seemed like maybe a correction was materializing, as the S&P 500 dropped by -1.1%, and the Russell 2000 Index fell by -3.5%. However, today the market is a little higher, so that leaves us wondering, was that it?

We don’t think so. Although the last market selloff was very shallow (the -4% S&P decline in November), we felt coming into this year that the market was probably overdue for a bit of a steeper decline that could carry the S&P down to around its 200-day moving average (blue line in chart below), which would be about -10%. Again, this was largely due to the fact that some signs of optimism are higher than they were last April, just before the market plunged by -17%. We don’t expect that there’s going to be a replay of last spring, but we don’t think a minimal, 2-day pullback is enough to clear the current overbought, over-bullish conditions.

Like Kissing Your Sister

Sometimes great minds think alike in the investment team, and I see that this blog overlaps the excellent piece on recent market performance that Carl posted on Friday. Nevertheless, here are a few additional thoughts on the topic.

The S&P 500 Index finished trading last Friday at a closing price of 1225. This is the same price the Index closed on 11/05/10, and it is +1.6% ahead of the close on 4/23/10, a period of close to eight months where stock investors have been disappointed. As I like to say, owning the broad market for the past eight months has been like “kissing your sister.” There just hasn’t been any thrill to being an equity investor when measured from the April market top. However, as Carl said last Friday, looking at the broad large-cap U.S. equity market doesn’t tell the whole story. For example, small-cap U.S. and mid-cap U.S. have both broken out to new highs as measured from the April peak (see chart on Carl’s blog). If you drill down into the S&P sectors and industries you find a number of fairly significant winners measured both from the April top and the November 5th top for the S&P 500 Index. Here are just a few sectors and industries that have performed well since April 23rd top and since 11/05/10. (Note: Pinnacle owns positions in all of these securities in various managed strategies.)

Gain Since 4/23/10

IGV Software ETF +13%

XOP Oil and Gas Exploration ETF +11%

IGN Networking ETF +7.1%

XLE Energy ETF +7%

XLY Consumer Discretionary ETF +5.6%

SPY S&P 500 Index ETF +1.6%

Lately we’ve been discussing the best strategy for buying this particular market. Should we view it suspiciously as the broad market has yet to convincingly break through important resistance that goes all the way back to late April? Or, should we be concentrating on individual sectors and industries that have already convincingly broken out to new highs and not worry about the broad market? Clearly tech, energy, and consumer stocks have resumed the bull market that began in March of 2009. In the past our investment process has focused on the broad market first. Presumably you could make the argument that waiting for the broad market to break out of its trading range is the more conservative methodology for risk averse investors. However, it may be that we have to switch gears here and begin to allow ourselves to invest more from the “bottom up,” meaning that we concentrate a little more on the sectors and industries. In a flat market like this, where gains might be fleeting, we may have to let the underlying sector performance guide our thinking more than it has in the past.

Breakouts

The stock market has had a very cheery start to December, which is typically the best month of the year. In just the first two trading days, the S&P 500 is already ahead by 3.5%. With all of the negative headlines swirling about the continuing debt problems in Europe, and on the heels of strong gains over the past three months, we’ve felt that stocks were probably due for a moderate correction on the order of maybe 5 – 10%. But, they only fell a little over 4% from the recent highs reached on November 5th before popping right back up in the past couple of days.

The S&P is back to 1218, just 9 points from its November 5th high. The Dow and NASDAQ are similarly back close to their highs. But a little more under the surface, there have actually been an increasing number of breakouts to new highs among other indices and sectors. Indeed, small and mid-cap indices, and the energy, materials, industrials, and consumer discretionary sectors have all made new bull market highs in recent days. Considering that the character of those stocks tends to be more cyclical, we believe it sends a signal of a growing confidence in the economic recovery at this point. We’ll be watching closely to see if the Big 3 large-cap indices play catch-up and register their own breakouts. If that happens, it would be a very favorable development for the bulls.

Chart: Russell 2000 Index

Taking Out the April High

The broad stock market indexes took out their April highs last week meaning that the bull market that began in March of 2009 is back in business. It has been more than 6 months since the S&P 500 Index hit its April high price of 1217 and then declined on fears that the problems in Greece and other “Club Med” members of the European Union might conspire to throw the U.S. economy, as well as the global economy, into a double dip recession. After finding a bottom on July 2 of this year, the market has rallied by 20% and due to the wonders of negative compounding, a 16% decline followed by a 20% rally gets us back to even. For those that might be wondering, bond investors fared much better from the April top to the current new S&P 500 high set last Friday. The Barclay’s Aggregate Bond Index gained 6.25% while stock investors just eeked out a 1.6% gain including dividends.

Of course bond investors have fared much worse on a relative basis since this cyclical bull market began in March of 2009. The S&P 500 Index including dividends has gained 87% while bonds have rallied by 15%. Finally, it is worth noting that stocks as measured by the S&P 500 Index are still trading 16% below the high set on 10/09/07 including dividends and 21% below the highs without dividends. Bond investors have earned a startling +24% over the same period. Investors are left to ponder what the next twist to this story might be. I have long argued that the S&P 500 Index is now trading in a gigantic range where the top is set at 1530 – 1540 (March of 2000 and October of 2007, respectively) and the bottom is 776 – 676 (October 2002 and March of 2009, respectively). If this is the case, then taking out this April’s high and closing at 1225 last Friday puts us 45% from the low and 25% from the high. It’s clear that the bulls have the upper the hand at the moment and while others will find intermediate points along the way for the market to find resistance to higher prices, the “granddaddy” of price resistance will be found above the 1500 level.

I’ve learned from painful experience that momentum can take financial markets far beyond what fundamental analysis might indicate is fair value. I wouldn’t be surprised at all if we make it all the way back to the top. The problem is that I haven’t been a believer in the underlying case for the bull market so far, and as long as residential real estate prices and massive unemployment continue to be a fact of our economic life, I will remain a skeptic. The Fed fired one of its last remaining bullets last week with a $600 billion plan to buy bonds with printed money, and the election basically ensures that there will be no more fiscal stimulus left to shore up the economy. The stock market is a leading indicator and the message for the past eighteen months is that the economy will expand and so will corporate profits. My ten cents worth is that it will be very hard to get overly bullish here, and that benchmark levels of risk would be just fine with me.

The Battle for 1050

The market seems to be locked in a heated battle around 1050 on the S&P 500. The index has been in a tug-of-war, crossing above or below 1050 in each of the past 5 trading days, which has been very interesting to watch. Last Friday, the bulls seemed to gain the upper hand. The market rallied for most of the day and closed at 1064. However, today, the bears fought back, pushing the market down to close at 1048. These latest gyrations, in a relatively tight range, reflect a high degree of indecision in the market, as investors try to digest the latest economic news, what the Fed might do next, the looming fall period, etc.

We’ve been viewing 1050 as an important price for most of the summer. The market briefly dipped below in late June/early July, but quickly bounced back into what we viewed as a sideways trading range that formed after the April peak. Closing decisively below 1050 in the coming days, in conjunction with the deteriorating economic backdrop, will likely compel us to take further defensive actions in Pinnacle portfolios.

Navigating the Range

Back on June 24th, I wrote that we wouldn’t be surprised if stocks remained mostly range-bound between 1,040 and 1,150 on the S&P 500 through the summer (http://echoesfromthepit.blogspot.com/2010/06/range-bound.html). Except for a brief dip below 1,040 in late June/early July, that’s how things have played out up to this point. Of course, the overall sideways trend in the market has been accompanied by an unsettling amount of volatility in both directions. Investors still seem to be going back and forth over whether another recession is a foregone conclusion, or if the decline from late April to late June largely discounted those concerns.

For our part, we’re trying our best not to rush to any conclusions, and to remain open-minded and flexible here. We’re concerned enough that we made a few adjustments in the past week to modestly lower volatility in client portfolios by reducing some highly cyclical equity sectors in favor of more defensive sectors, largely due to increasing signs that the economy is slowing. But at the same time, we haven’t decided to fully batten down the hatches yet. With the occasionally treacherous fall period looming, we’re making sure to stay on our toes.

S&P 500 Index: Still Range Bound

Market Update

The S&P 500 has bounced over the past several trading days, gaining a little more than 8% from its intraday low of 1,011 reached on July 1st through its close at 1,096 today. The latest move isn’t totally surprising, since the market was oversold on many measures at its recent low. However, technical damage was incurred on the way down, and we now see several levels of resistance that the market must make its way through before the overall picture begins to improve.

The first hurdle ahead is the flattening 200-day moving average (brownish line on chart) at 1,112, which is just 1.5% higher than today’s close. Next up is the June 21st intraday high of 1,131, which is about 3% higher. After that is the January 19th high at 1,150, a 5% move higher. Then there’s the May 13th post-flash crash bounce high of 1,173, which is 7% up from here. Finally, the recent rally high of 1,220 reached on April 26th looms, which is about 11% higher. In addition, the market currently appears to be trying to break through the down-sloping trend line that connects the April and June highs, which would be the first sign of progress if accomplished.

In short, from a technical perspective, we see multiple levels of resistance that the market must work through before regaining the upper hand and possibly resuming the rally that began 15 months ago. Despite the recent bounce, we are not out of the woods yet.

Chart: S&P 500 with downtrend line (blue) and resistance levels (red)

DEFCON 2

I spoke with senior portfolio analyst, Carl Noble, this morning and he informed me that we are moving portfolio trader, Tim Mascari, to “Defcon 2.” Defcon is a term usually used to describe the readiness condition of the U.S. armed forces, and getting to Defcon 2 is a very rare occurrence (Defcon 2 is the highest confirmed level ever reached). For us, this morning’s news that China’s economic growth forecasts are being revised downward has moved the S&P 500 futures lower, indicating that the stock market will open lower today. As the market (once again) drifts down to our stop-loss point of 1,040 on the S&P, we are (once again) spending significant time analyzing what moves to make in order to have the portfolio properly reflect our view of market risks and possible rewards. Having Tim at Defcon 2 means we are completely ready to execute transactions across our many managed accounts if necessary.

In yesterday’s investment team meeting we noted that we have several choices in terms of how to marginally reduce portfolio risk and volatility if we hit the stop. One choice would be to significantly reduce our U.S. equity holdings but keep some very high octane industry sectors that should be the market leaders if we get a bounce off of the lows. Another choice is to significantly restructure the risk in the fixed income side of our portfolios and make a much larger bet on duration versus credit. Basically, that means that we would sell corporate bonds and buy U.S. Treasury bonds. Notably, this morning the U.S. Ten Year Treasury is trading to yield of less then 3%. This once again reinforces my belief that our ability to do this job is often constrained by our lack of imagination. It‘s pretty amazing to see the yield fall this far. Back to Monday’s conversation, we decided to reduce our equity holdings by picking and choosing targeted securities among the cyclical sectors of the portfolio without completely restructuring our U.S. positions. This seems appropriate as, at least for us, the jury is still out regarding how slow the economy will be in the second half of the year. If this is a precursor to a typical mid-cycle correction (a term you are going to be hearing a lot more about), then we shouldn’t get too far out of the market.

The last agenda item yesterday was to discuss the themes for our end of quarter market review. Surprisingly, the time has passed and we are already at the end of the calendar quarter. The guys in the Pit will do their usual excellent job pulling it together, and I don’t want to give it away, but I can say I was happy with our portfolio results for the last quarter. One of the inputs to our asset allocation decisions is how our portfolios are “working” in the current market environment. Unofficially, the numbers appear to be confirming what we already knew, which is that portfolio correlations have been very low, which means that downside volatility has been contained. I’m guessing Pinnacle Moderate portfolios only caught about 25% of the second quarter market decline. That news has an impact on the changes we will make to asset allocation if we hit our stop. I’m very comfortable that risk is being properly managed here.

Range Bound?

The markets have remained volatile this week. Recent economic reports have largely been disappointing, particularly the latest housing market data. While certainly concerning, we don’t think enough evidence has accumulated to join the double-dip recession crowd at this point. Overall, the market seems to be digesting some degree of slowing in the U.S. economy. It may be a rocky summer as this process continues, with the market lurching in both directions on the latest news.

We wouldn’t be surprised if the market is largely range-bound between the February/May/June low of 1,040 on the S&P 500, and the January high of 1,150 for the next several weeks. If that happens, it would reflect a level of indecision among investors as they try to determine whether there’s more in the tank for this bull market, or if it’s time to take profits. That’s not a terribly exciting scenario for investors, but it may be what’s needed after the large swings of the past couple of years.

Chart: S&P 500 Index, with possible sideways trading range

When Everybody Knows the Playbook

Well, it looks like we dodged the S&P 500 Index at 1,040 sell bullet. The market has bounced nicely from that level and is currently trading at 1,094. I always wonder what it means when institutional investors are all looking at the same charts showing the same resistance and support levels for the market. In this case, 1,040 was truly the last line of technical defense for the S&P to the downside and we have been writing that we would be reducing risk if the market closed below that price. Since everyone else was looking at the same chart, you wonder how much of the subsequent rally was a self-fulfilling prophesy…at least in the short-term.

Where does the playbook go from here? I believe that the same institutional investors who were playing for the rally off of the 1,040 level will now be looking for a classic summer rally. It is well known that the typical market cycle leads to the conclusion that investors should “sell in May and go away.” Perhaps a little less well known is the May sell-off is often followed by a relief rally in June and July. It is when you get to late summer that history suggests that extreme caution is appropriate. History is full of market swoons that begin in August and continue falling through September and October. So, looking at a chart it seems very clear that the current rally could take the market back to its 50-day simple moving average of 1,145, or even back to its April 23rd high of 1,217. If you get there on the rally…it’s time to sell. In a lousy year for stocks, who can afford to give up the next 10% to the upside if you can get in and get out?

So everyone will be playing chicken with everyone else, intently studying the “quality” of this rally (if it continues). In a perfect world we will see a rally in the euro, a sell-off in U.S. bonds and gold, and a return to market leadership in the late cyclicals in the U.S. market, meaning big gains for energy, materials, and industrials. If the rally plays out according to the playbook, then everyone will be looking to sell into it, hoping to catch as much of the gains as possible before we get to the late summer market doldrums and the outright fall market nightmares. The question is, if everyone knows the playbook, and institutional investors are trying to invest the same seasonal strategy while looking at the same market themes and levels of price support and resistance, doesn’t that completely invalidate the playbook? I know that we are cautiously playing for this summer rally. I also know that we won’t be surprised by a completely unexpected market move…in either direction.