After faltering for the past week, stocks rallied Thursday morning on news that third quarter GDP was slightly stronger than expected. The 3.5% growth rate ended four quarters of economic contraction.

U.S. Commerce Secretary Gary Locke issued the following statement in response to the news.

“Today’s numbers indicate that the tough decisions this administration made to rescue the economy from the abyss were correct. We’re headed in the right direction, and even though there are still too many Americans out of work and still much work to be done, without the action taken in the early days of this administration, the pain families are feeling today would be much worse.”

There is little doubt that investors and traders will be encouraged by this news and that stocks will continue to rally. Unfortunately, a positive GDP number does not mean that the economy has returned to full health. In fact, there are numerous signs that point to continued economic weakness.

The current situation reminds me of 1999, when many experts were warning about the inflated valuations of technology stocks. In spite of those warnings, people continued to buy technology stocks and drove the prices even higher. Eventually the tech bubble burst, because that’s what happens in any situation where something gets so overextended.

Today the P/E ratio for the S&P 500 remains near an all-time high, yet investors continue to bid up the price and the valuation. This is in spite of the fact that almost 1 in 5 people are out of work and federal deficits are rising at an unprecedented rate.

Below is a chart of the New York Stock Exchange composite. The gold line is a 50-day moving average (MA) of the price. In recent days the MA was breached, but today’s positive market action is likely to push it back above that mark.

The middle portion of the chart is a relative strength index. This indicator broke below the 50 level but today’s action should also push it back above that mark. That is usually an indication that an investment has enough momentum to sustain an advance.

The bottom portion of the chart is a moving average convergence divergence (MACD). This indicator is also turning upward again in response to market action.

Because the rally is expected to continue, we will cautiously be entering some market positions. As indicated above, market values for many stocks are currently inflated meaning risk of a significant correction remains high. So we will be very selective in the investments we choose and we will trust our indicators to warn us when it is time to get back out.

It is impossible to predict when the next major downturn will occur. It might be a month from now or it might be several months. In the meantime, we will try to use this opportunity to take advantage of Wall Street’s optimism.

F.S.