Topped Out? Number 3 in a Series

This is the third "Topped Out?" article. The last one was in October.

The key questions are, Has the market rally ended for awhile? Is it time to take profits off the table, go to cash, or go short? Should we go into the woods where the bears hang out? Last time, I concluded that the rally probably had a while longer to run. I promised to write another article if the market experienced a decline of a couple of weeks, or if any of my sell-stops got hit.

After that article, the market--as measured by the S&P 500--advanced an additional 10%, for a total 70% gain since the rally began on March 10, 2009.

But this past week, one of my sell-stops got hit. So I am back with a new article.

As frequent readers know, I have used simple 8% trailing sell-stops to protect my gains during the rally. Last week, for the first time, one of the stops--on QQQQ, the Nasdaq-tracking ETF--got hit, and those shares sold off. They were just a small part of my Capital Gains portfolio. The stop on SPY--the S&P 500 tracking ETF--sits at $105.40 compared to Friday's closing price of $107.39. In other words, that stop will get hit if SPY's price falls about 2% more. SPY represents the majority of my holdings. I also hold a minor position in IBM, and its stop is similarly close to being hit. If all three are hit, my Capital Gains portfolio will be 100% cash for the first time since last April 2, when I began buying into the rally on a determination that the upward trend that began on March 10 could be sustained for awhile.

That determination turned out to be true, as the rally lasted about 10 months and gained about 70%. It has been one of the best investment opportunities since I have been investing in stocks.

However, in just the last 8 trading sessions, the S&P 500 has dropped from 1150 to Friday's close of 1074. That's a decline of more than 7%. Furthermore, Friday's close was about the same as the close on November 6--almost three months ago.  So the market has basically gone sideways for 3 months.

Is the rally over? I think there is a high probability that it is.

As I have stated many times, this has been a news-driven bull market. It is not unusual for the stock market to stage a strong advance during a recession. Of the previous 9 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 exactly what happened here, starting last March. Why? Because investors were looking forward with hope to the end of the recession and the return of an expanding economy.

What gave them such hope? Positive news. A rally such as the one we have had requires investors to receive what I call positive "net news flow," plus a collective sentiment to back up their beliefs with dollars. Investing those dollars in the market causes prices to rise.

Last March, most any piece of economic data that was "less bad" could be interpreted positively, indicating that the downward economic cycle was losing steam and bottoming out--a necessary precondition to the economy turning back upward. Over the following few months, most indicators slowed their descent significantly, and some turned upwards. Many investors were convinced that the recession was indeed over.

However, in the past few weeks, both the news and the sentiment have changed. Some of the news has remained good. For example, the companies that have reported so far in the current earnings season are beating Wall Street's consensus estimates at about the same rate that they did in the last earnings season. At the end of last week, the government reported a preliminary estimate that GDP rose at an extremely healthy annual rate of 5.7% in Q4 2009, far exceeding expectations of 4.6%.

But a lot of the news has either been lackluster or has indicated that economic growth may be stagnating, despite the positive GDP report. For example, unemployment seems to have become an intractable problem, not responding very much to numerous governmental measures--including the original TARP stimulus package, now over a year old. Tellingly, the Fed itself, in its policy statement accompanying its decision last week to keep short-term interest rates at record lows, stated once again that the reason it was holding rates so low was that it anticipated a slow economic recovery. Statisitics about bank lending continue to be uninspiring. Various economic indicators seem to have flattened out rather than turning decisively up.

In the last article in this series, I concluded that the net news flow was a 6 on a scale of 10. Now, despite the strong earnings reports coming in and the GDP number, I would say that the net news flow is no better than a 4 or 5 on a scale of 10.

In addition to the news itself, there is the issue of sentiment--how are investors reacting to the news? That seems to have taken a turn from hopeful and optimist to doubtful and pessimistic. For example, on Friday, when the 5.7% GDP number was announced, the market fell more than 1%. Normally, you would expect the opposite reaction. Many investors are connecting the dots to conclude that the economy--which in the USA is comprised 65% to 70% of consumer spending--cannot improve significantly unless and until the unemployment rate makes notable improvements. Same as to the housing market. Many are also simply sick of all the government involvement. They want to see more signs of privately driven economic improvements. At the end of the day, many investors seem to have become skeptical that the economy is turning the corner. On message boards and blogs, some investors are expressing disbelief in government numbers themselves, preferring to believe the anecdotal evidence they see with their own eyes, such as neighbors (or themselves) being outof work. Undoubtedly, a lot of investors are just tired of the rally and think it is time to take profits by selling their stocks. Just this past week, I saw a blog commenter put the folowing odds on a continuation of the bull market:
--Probablity of bull market intact: 15%
--Probability of range-bound market: 45%
--Probabilty of bear market: 40%

That about matches my own feelings. So whereas last time, I concluded that the rally probably had more oomph left in it, this time my conclusion is that it probably does not. If my SPY sell-stops get hit in the coming week or two, I will remain in cash waiting for the market to issue a clear sign that it has resumed a definite upward trend.

Timing Outlook Remains Positive, But Falls Significantly

1. Summary

After rising out of its tight December trading range and getting off to a good start in 2010, three straight days of double-digit losses this past week pulled the S&P 500 from a close of 1150 on Tuesday, January 19 (its highest close in the 10-month rally) all the way down to 1092 by Friday, January 22. In other words, the S&P 500 lost 5% in three trading sessions. Ouch.

The Timing Outlook falls from 8.5 last time to 6.0. While still positive by definition, the sudden drop over the last three trading days had the look of the index falling through a trap door. Recall that last time, for the first time since the rally began, a single component of the Timing Outlook turned negative: The P/E of the S&P 500 (as computed by Morningstar) hit 21.3, just above the neutral-range cutoff of 21.2. I asked then if that was the canary in the coal mine? Maybe it was.

I have been saying for months that the market rally was news-driven, with the “net news flow” seeming to herald what the stock market would do. This past week, the net news flow turned decidedly negative. Within just a few days:

• The major indexes suffered large losses for three straight days--what the indexes do is not only the result of news, it is news itself, as it affects investor sentiment and can stoke optimism or greed on the one hand, or fear and pessimism on the other;

• President Obama attacked the big banks twice, first by suggesting a tax on their trading profits, then again by announcing plans to regulate their size and risky trading practices;

• Some opposition surfaced in the Senate to the re-appointment of Ben Bernanke as head of the Federal Reserve;

• Word of a possible economic slowdown in China seemed to make some investors nervous, especially over the possibility that it might spread;

• Some earnings reports disappointed investors—-Kimberly-Clark surprised to the downside, annual revenue at McDonalds fell for the first time in at least 25 years (although the company’s profits rose), and Google’s results seemed to disappoint even though they reported record profits;

• Unemployment rose to the top of the heap among disappointing economic news.

To quote from the Timing Outlook last time, “As regular readers know, I think this whole rally has been news-driven, and I think it will continue to be that way. If we get positive news, on balance, I believe that the market will respond positively. If the news is overall negative—particularly if it suggests that the fledgling economic recovery is stalling out—then I think the market will fall back and the rally will be over.” I still believe that. While one week’s worth of bad news is not enough to make the overall news flow become negative from a longer-term perspective, another week or two could do so.

What I’ve been calling the fine print now turns into bold-face type: The market can turn on a dime, as last week proved. As always, sell-stops or some other form of downside protection is recommended on long stock positions. I generally exclude from this advice stocks held for their dividends rather than for price appreciation. My own practice is to evaluate dividend stocks on the basis of their dividend stream and apparent reliability, not on what the stocks are selling for at any given time.

2. Market Performance Since Last Outlook
(“now” figures are as of close Friday 1/22/10)

Last Outlook (1/4/10): 8.5 (positive)

S&P 500 last time (1/4/10): 1115
S&P 500 now: 1092   Change: -2%

S&P 500 at beginning of 2010: 1115
S&P 500 now: 1092   Change in 2010: -2%

S&P 500 at close 3/9/09: 677
S&P 500 now: 1091   Change since 3/9/09: +65%

3. Indicators in Detail

• Conference Board Index of Leading Economic Indicators: The latest report issued in January showed the ninth consecutive monthly increase. Positive. +10

• Fed Funds Rate: No change. The Fed Funds rate remains near zero. Positive. +10

• S&P 500 Market Valuation: (Source: Morningstar’s calculation of P/E based on operating earnings.) The current P/E of the S&P 500 is not shown today on Morningstar, not sure why. Last time, it had jumped into the overvalued range, so with this week’s market drop, I will assume it has fallen back to neutral territory. +5

• Morningstar’s Market Valuation Graph. This indicator has been meandering small distances around 1.0 (“fair value”) since late July, 2009. It now stands at 1.00, down from 1.02 last time. That suggests the market is fairly valued right now. +5

• S&P 500 Short Term Technical Trend: This past week, after peaking at a close of 1150 on Tuesday 1/19, the S&P 500 experienced three straight double-digit drops, closing at 1092 on Friday 1/22. That pulled the index down through its 20-day AND 50-day simple moving averages (SMA), although it happened so fast that the 20-day SMA is still above the 50-day SMA. So the relationship of the index to its key SMAs is: 20-day SMA > 50-day SMA > Index > 200-day SMA. This is considered neutral, although if the market drops continue, the 20-day SMA will fall through the 50-day SMA soon and make this indicator negative. Neutral. +5

• S&P 500 Medium Term Technical Trend: This trend, which uses the 50-day and 200-day SMAs, falls from positive to neutral. +5

• DJIA Short Term Technical Trend: Same configuration as with the S&P 500. Neutral. +5

• DJIA Medium Term Technical Trend: Neutral. +5

• NASDAQ Short Term Technical Trend: Same pattern as the other two. Neutral. +5

• NASDAQ Medium Term Technical Trend: Neutral. +5

TOTAL POINTS: 60    NEW READING: 60 / 10 = 6.0 = POSITIVE

Just Launched! THE TOP 40 DIVIDEND STOCKS FOR 2010: How to Generate Wealth or Income from Dividend Stocks

I am happy to announce that this year's dividend e-book has just been launched. It's title is THE TOP 40 DIVIDEND STOCKS FOR 2010: How to Generate Wealth or Income from Dividend Stocks.

The book follows a similar format to last year's. It has grown by about eight pages to allow for updated discussions, new examples, and several new features. The new features include:

--A glossary of dividend terms. Not sure what "ex dividend" really means? Now you'll know.

--A more complete discussion of my own Dividend Portfolio. This portfolio, which is tracked monthly on my Web site, is based on the investment strategies and stocks in the annual TOP 40 series. It does not invest in all 40 stocks. Rather, it is a "demonstration portfolio" designed to illustrate the use and application of the principles and stock picks in the TOP 40 series. It is a real-money portfolio, with real costs, funded with my own money. It is not a hypothetical or model portfolio, nor a phonied-up "backtest." The money has been and will continue to be invested in real time.

--A modification to the scoring system. The changes this year place a little more emphasis on higher-yielding stocks without adding appreciably to risk.

--A discussion of what to do with stocks purchased from 2009's list that did not make 2010's list. This is the most important new feature. There are many reasons that a stock on 2009's list did not make 2010's list. For example, a couple of good stocks fell off the list because price run-ups caused their yields to drop below minimum requirements. But if you bought them in the past, you have already locked in better yields, and as long as the stock keeps raising its dividend, there's no reason to sell it. It is doing exactly what you want it to do.

For a complete description of the new TOP 40 DIVIDEND STOCKS FOR 2010, just click on the cover image in the right-hand column.

As always, whatever your investing philosophy--from fast trading to slow-but-steady growth through dividend investing--best of luck in 2010 and always.

Dave

Top 40 Dividend Stocks for 2010--Almost Ready

The 2010 edition of THE TOP 40 DIVIDEND STOCKS is almost ready. My wife and I are going on vacation on January 21, so it will be out before then.

In the past month, I have:

--Completed all the screening and scoring to select the Top 40. Barring a last-second surprise, the list is finalized. I have systematically reduced about 700 initial candidates down to what I think are the best 40 dividend stocks for purchase in 2010.

--Completed two drafts of the text, adding updates and final 2009 data, plus a few new features.

--Completed the Easy-Rate scoring sheets for the Top 40. There are still a few loose ends to tie up here.

What I am working on right now:

--Giving the text a final reading, correcting any errors, inconsistencies, and cosmetic issues. I'll finish off with a spell check.

--Cleaning up the loose ends in the Top 40 Easy-Rate sheets.

What remains to be done before launch:

--Convert the ebook, which I produce in MS Word, to an Adobe Acrobat pdf document.

--"Take down" last year's e-book from Payloadz, the distribution service that I use.

--Upload the new e-book to Payloadz and get their XML code for the "BUY" button that appears on my website.

--Lots of work on my website. I need to find all the pictures of last year's cover and replace them with a jpeg of this year's cover; replace last year's XML code from Payloadz with this year's, so that readers are directed to the correct new product; update (and maybe rewrite) the "landing page" where people interested in learning about The Top 40 Dividend Stocks for 2010 are directed.

--Publish the new website.

--Do a "test purchase" to make sure that everything is working among Payloadz, the new XML code, the interface with PayPal, the sending of download instructions to clients, and actual successful downloading of the e-book.

The price will remain the same as the first two years at $39.

I mentioned that I have added a few new features this year:

--A glossary of dividend terms.

--A more complete discussion of my own Dividend Portfolio, which is based on the Top 40 series.

--A modification in the scoring system to place a little more emphasis on higher-yielding stocks without adding appreciably to risk.

--A discussion of what to do with stocks purchased from 2009's list that did not make 2010's list. (Hint: In most cases, keep them.)

So, it's in the home stretch. As soon as it is available, I will announce it here as well as on the main website. Then it's off to Hawaii!

Rally Continues; Timing Outlook Remains Positive

(Note to subscribers: The e-mail subscription version you receive omits some formatting such as boldfacing and other cosmetic niceties. Links are also harder to see. If you want to view this post in its most pleasing format, just click on the title above, which is a link that will take you directly to this article in my Newsletter.)

1. Summary

The market finally rose out of its tight trading range in the second half of December, with the S&P 500 piercing 1120 last week (actually getting over 1125) before falling back on Thursday (the last trading day) to finish at 1115. The 1120 mark had been viewed by market technicians as “resistance” on the rally, and the extended sideways market—with the failure for several weeks to exceed 1120—had led some to suggest the 10-month rally was over. Now that 1120 has been exceeded, we’ll see whether the rally will continue.

The Timing Outlook suggests that it will, remaining positive at 8.5, same as last time. This is the 19th consecutive positive reading, essentially coinciding with the market rally that began on March 10, 2009. The rally has lasted almost 10 months and risen 65% without so much as an 8% correction along the way. One note: For the first time since the rally began, a single component of the Timing Outlook turned negative: The P/E of the S&P 500 (as computed by Morningstar) hit 21.3, just above the neutral-range cutoff of 21.2. This will be worth watching over the next few weeks. Is it the canary in the coal mine?

With the turn of the new year, the next earnings season is right around the corner. Last earnings season brought mostly positive news, with about 75% of companies beating earnings expectations and around 60% beating revenue expectations. Forward-looking statements were mixed, but it would be fair to call them slightly positive on average. As regular readers know, I think this whole rally has been news-driven, and I think it will continue to be that way. If we get positive news, on balance, I believe that the market will respond positively. If the news is overall negative—particularly if it suggests that the fledgling economic recovery is stalling out—then I think the market will fall back and the rally will be over.

The fine print: The market can turn on a dime. As always, sell-stops or some other form of downside protection is recommended on long stock positions. I generally exclude from this advice stocks held for their dividends rather than for price appreciation.

2. Market Performance Since Last Outlook
(“now” figures are as of close Thursday 12/30/09)

Last Outlook (12/13/09): 8.5 (positive)
S&P 500 last time (12/13/09): 1106
S&P 500 now: 1115 Change: +1%

S&P 500 at beginning of 2009: 903
S&P 500 now: 1115 Change in 2009: +23%

S&P 500 at close 3/9/09: 677
S&P 500 now: 1115 Change since 3/9/09: +65%

3. Indicators in Detail

· Conference Board Index of Leading Economic Indicators: The report issued in December showed the eighth consecutive monthly increase. Positive. +10

· Fed Funds Rate: No change. The Fed Funds rate remains near zero. Positive. +10

· S&P 500 Market Valuation: (Source: Morningstar’s calculation of P/E based on operating earnings.) The current P/E of the S&P 500 is 21.3, up from 20.0 last time, and the first time in quite a while that this indicator has exceeded the neutral range of 17.4 to 21.2. Negative. +0

· Morningstar’s Market Valuation Graph. This indicator has been meandering small distances around 1.0 (“fair value”) since late July, 2009. It now stands at 1.02. Thus the market is “fairly valued” by this indicator. (Interesting historical data: All-time low = 0.55 on 11/20/08. Value at end of dot-com bear market = 0.78 in 10/02, which kicked off a 5-year bull market. Most recent low of 0.62 coincides with market’s March 9 low. All-time high = 1.14 at the end of 2004.) Neutral. +5

· S&P 500 Short Term Technical Trend: Although the S&P 500’s chart wandered back and forth through its 20-day simple moving average (SMA) a couple of times during its sideways period in November and December, it currently is in its most favorable configuration: Index > 20-day SMA > 50-day SMA > 200-day SMA. It may also be worth noting that the sideways action tightened up the 20-day and 50-day SMAs, which are now just about 8 points apart. Positive. +10

· S&P 500 Medium Term Technical Trend: Positive. +10

· DJIA Short Term Technical Trend: Same story as the S&P 500. Positive. +10

· DJIA Medium Term Technical Trend: Positive. +10

· NASDAQ Short Term Technical Trend: Same pattern as the other two. Positive. +10

· NASDAQ Medium Term Technical Trend: Positive. +10

TOTAL POINTS: 85 NEW READING: 85 / 10 = 8.5 = POSITIVE