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.