Topped Out? Number 2 In a Series

This is the second "Topped Out?" article. The idea is to explore whether the market rally has ended. The questions now are, Has the market run-up ended for awhile? Is it time to take profits off the table, to go to cash, or to go short? Should we go into the woods where the bears hang out?

This has been a great rally: The S&P 500 is up 60% since March 9. But it has gone backward in two of the past four weeks, including -1% last week. Hence this second article in the series.

As I have stated many times, this has been a sentiment-driven bull market. While it has been more powerful than most, in many ways it is a garden-variety recession bull. Of the previous nine recessions before the current one, the stock market bottomed out and started back up several months in advance of the end of the recession. That's what happened here, starting in March. Why? Because investors were looking forward with hope to the end of the recession and the return of an expanding economy.

I use the term "net news flow" to explain what stock buyers have been reacting to during this bull market. They have been reacting to signs--indications--that the economy might be pulling out of the recession. Last March, most any piece of economic data that was "less bad" could be interpreted positively, that the downward economic cycle was losing steam and bottoming out--a necessary precondition to the economy turning back upward.

By now, most indicators have slowed their descent significantly, and some have turned upwards. For example, on Thursday the Conference Board reported that its Index of Leading Economic Indicators rose for the sixth straight month. I track several important indicators in my bi-weekly Timing Outlook reports. Those reports have been positive since March, suggesting that the short-term direction of the market would be up.

In the Q2 earnings season in July-August, about 75% of companies reported earnings that were "positive surprises." That means that they exceeded the consensus expectations of "The Street" (that is, the consensus expectations of stock analysts). All of the positive surprises contributed greatly to a positive net news flow that helped the rally along. In most cases, the Q2 reports did not reflect growing revenue or earnings compared to a year ago, or even to the previous quarter. They simply reflected better-than-expected earnings, a low hurdle to clear. Most of the companies cleared it via fast cost-cutting, including layoffs and hiring freezes.

My thought on the market's reaction to the Q2 earnings reports was that investors were giving companies a "free pass" on revenue improvements. You cannot improve earnings forever by cutting costs. My expectation was that investors would not be so lenient the next time around: They would be looking not only for positive earnings surprises, but also for positive revenue surprises and optimistic forward-looking statements.

Lots of people are skeptical about the sustainablitily of the rally. They are uneasy about its sharpness (one of the strongest short rallies in history), unconvinced that it is supported by real economic improvements, dismayed by the seemingly intractable unemployment problem, and disgusted with government involvement via TARP and other bailout programs. They think a correction (a short-term 10% drop) is inevitable, if not an all-out crash if we get a "double-dip" recession.

The Q3 earnings reports started flowing about two weeks ago. So back to the question: How is the net news flow? According to Bloomberg, Q3 earnings are running very positively. By their count, through last Friday, 85% of companies have beaten consensus expectations. Perhaps more importantly, revenues being reported are better than expected, as 65% of companies have beaten consensus expectations for revenues. And a fair number of companies have included positive forward-looking statements on both earnings and revenue.

How to interpret all this? I would say the news flow is slightly positive, maybe a 6 on a scale of 10. Not blowing the doors off, but perhaps good enough to sustain this rally for a while longer.

Frequent readers know that I already have my exit strategy in place for my Capital Appreciation Portfolio. It has three holdings: SPY (the ETF that tracks the S&P 500); QQQQ (the ETF that tracks the NASDAQ); and IBM. The two ETFs are protected by 8% trailing sell-stops that I update each weekend. I have a 10% trailing sell-stop under IBM.

I am comfortable with my sell-stops. If the market turns downward for a prolonged period of time, they will get me out with most of my profits intact. I suggest that readers protect their long positions in a similar fashion. At any rate, it is too soon to declare that the market has topped out. If the market struggles for a couple more weeks, or my stops get triggered, I'll be back with another report.