An interesting article on YAHOO! Finance this week posed the question: “Is This Rally Out of Sync with the Economy?” Written by Simon Maierhofer, he explains that “For nearly five months, the major U. S. indexes … have been climbing higher and higher. Simultaneously, economic numbers continue to disappoint.”

When the current rally began in March, I warned investors to be cautious because surging advances during bear markets tend to become traps that quickly turn down and punish investors who jump in too soon. But the next leg of the bear market has so far failed to make an appearance. We saw a decline in June and it appeared our caution might be vindicated. But then stocks rose strongly again in July.

It is tough for a professional money manager to watch the market rise and realize that his clients are not participating. However, our foremost responsibility is to protect clients’ assets against unnecessary risk and during this entire advance, risk levels have been and remain high. 

In 2008 we were heroes because we anticipated the downturn and moved most client assets to money market funds. We sidestepped the major downturn and have largely watched from the sidelines ever since. Now in 2009 major indices have finally recouped their losses from earlier in the year and are showing some gains. With media reports from some analysts saying that the bear market is over, investors who have been waiting on the sidelines are beginning to feel left behind. But just because there are a few signs of economic improvement does not mean the danger is past.

As noted in last week’s blog, earnings on the S&P 500 are at an all-time low while valuation (as measured by the P/E ratio) is at a record high–far beyond any level ever recorded. Those are warning signals that would be irresponsible to ignore. Maierhofer’s article also mentioned the disappointing corporate earnings and the valuations that are out of whack. 

“Discerning the true value for stocks is actually quite simple, if you are humble enough to stick with a simple concept. During prior bear market bottoms of historic proportions, P/E levels, dividend yields, and mutual fund cash reserves have always reached levels indicative of a market bottom.

“Unless those indicators provide their stamp of approval, the market is overvalued and any rally will turn out to be short-lived. Based on those indicators, the market is grossly overvalued, still.”

I have spent about 20 years in the investment industry. Prior to that, I worked 10 years as a hard news journalist. I can never recall another period where negative economic news was so easily dismissed. Nor can I recall another time when the tiniest glimmers of positive news were so eagerly touted and embraced.

Again quoting from Maierhofer’s article: “The 9.5% unemployment rate does not reflect the 4.4 million people who’ve been unemployed for more than 27 weeks, or the employees who’ve been forced to work less and make less. As part of the above mentioned cost-cutting efforts, companies cut the hours worked by a record 2.3% to an all-time low 33 hours. The ‘all-inclusive’ unemployment rate published by the Bureau of Labor Statistics is 16.4%.”

Perhaps I am naive but I do not believe the stock market can continue to advance with unemployment above double-digit levels and with the S&P 500 at exceedingly high valuations. 

One final quote from Maierhofer: “During the Great Depression, the stock market declined in steps.  A 48% decline was followed by a 48% rally. The next 47% decline was followed by a 23% rally. This process continued until the Dow Jones lost over 89% of its value.

“Investors who jumped back in after the initial 48% decline saw their portfolios dwindle by yet another 60%. Investors who thought they were ‘bargain hunters’ after the second rally, found out that their bargains were a money pit. The cycle continued until the market had destroyed the financial existence of many.

“This rally is simply here to relieve investors’ pent-up urge to buy and recreate an environment that will drag the maximum amount of money back into the losing vortex.”

I do not profess to be able to predict what the markets will do. I can, however, compare past experience to current situations to help make decisions about what is likely to occur, based on similar historic events. During this current rally, the Nasdaq has been the strongest of the major indices. All technical indicators for this index are currently positive and if they remain so, at some point we will no longer be able to remain on the sidelines.

But we all know that markets are cyclical and right now, technical indictors are showing that a downward cycle might soon emerge. Below is a two-year daily price chart of the Nasdaq. The rally we have seen over the past few months is clearly visible. The middle portion of the chart is a Relative Strength Index (RSI). Notice that it recently approached 80. That is a very high level that is difficult to maintain. In fact, the only other time during the past two years that it neared this high level was in October 2007 and a significant downturn followed.

The bottom portion of the chart is a moving average convergence divergence (MACD). It is also at a highly overbought level, which normally would indicate that a downturn is immanent. But a closer look reveals that since April, the Nasdaq has spent most of its time at levels that would be considered overbought.

From a technical perspective, these indicators lead us to expect some sort of a market pullback, but it is impossible to know how much of a decline to expect. For several months major indices have resisted a significant drop, even though economic fundamentals show that the economy remains mired in recession.

If we see only a brief correction and then major indices rally again, we might cautiously enter a few long positions. But for the immediate future, the best course would seem to be to remain patient and wait for the right opportunity. 
F.S.