Rally to Follow Correction?

April 22, 2013

It is normal for stocks to take a period of time to complete market tops.
-Dr. Frank James, founder, James Investment Research

It was a tough week for the market averages as the Dow lost 2.1% and losses exceeding this were common in the small capitalization stocks. Staples, telecommunication and utilities prospered but other sectors declined, with energy and information tech down more than 4%. A total of 920 stocks advanced against 2258 declines, while almost 300 stocks hit new highs while half that number hit new lows. Volume came in as prices declined while Tuesday and Friday advances were on lighter volume. Commodities caught the eye of observers, with indexes down across the board, and gold, copper and tin leading the pullback. These are not good omens.

Sentiment among professionals is bullish. Barron’s reports: “(their) poll of professional investors is also setting a record—for all time high for Big Money, going back more than 20 years.” Investors Intelligence index of bulls/ bears soared above 30 before falling back to 26, still too bullish but falling. Many smaller investors appear to be more cautious...however, my survey among friends including an accountant, a college professor, and a lawman found them agreeing the market would “keep chugging along” with no big break in store.

Meanwhile, the Leading index declined .1% last week when a rise was anticipated, business equipment investment disappointed, and the coincident/lagging index fell from 89.1 to 88.7. General Electric services a wide variety of markets, it reports industrial sales and profit margins are falling. Europe and China continue to show signs of slowdowns and auto sales in Europe are at a 20 year low. Of course, these are problem areas for our manufacturers and exporters.

It appears fair to conclude the gush of printing press stimulus may have bolstered activity, but not to the point of overcoming an inhospitable business environment. Retail sales are now faltering, housing traffic has declined, and FED districts report disappointing prospects. With the size of consumers in the economy, consumer spending downturns are important. In this respect, the Wall Street Journal notes that the real wages of workers have declined over the past year.

It is normal for stocks to take a period of time to complete market tops. Prices tend to surge up and down, while sellers promote rationales for optimism. All the while, reality undercuts price support. Eventually, bad news overcomes and prices go lower. Reality today is seen in the releases of corporate earnings, and the news is not good. Cost cutting improves profits, but among SP 500 firms more than half of the revenues are disappointing, an omen of problems in the future.

The topping process appears to be well underway, with stocks rising on light volume but falling with heavier trading. We have been urging caution: “After a 23% rally from last June, we think the market is peaking and starting to offer more risk than reward. We may have another bounce or two left, but we need to begin shifting our focus to preserving capital. As such, we will start to reduce equity levels in overinvested accounts.” (7 April 2013) “Last week we noted these indicators appeared to be shifting out of the neutral camp and into the unfavorable arena. Market tops can last for extended periods this does not necessarily suggest stocks have to decline in the immediate future. It does however suggest risk levels are now elevated. Prudent investors may begin to lower equity levels where appropriate for their objectives. (14 April 2013)

Stock averages were bumping up against old highs, now we are in the midst of a 5% downward correction. At this point we need to watch the strength of the rally which will follow this correction, a weak rally could be taken as a sign of topping. Our leading risk indicators continue to suggest caution is in order, and we would not hesitate to take profits on strength.