It’s always nice to start a New Year with hope for something better. When it comes to the financial markets, there are reasons to hope that 2011 will be a good year for investors. While 2010 produced positive returns in major indices, those gains came with plenty of uncertainty. Choppy markets had people uncertain about how the year would end. As late as the last week of November, it appeared that there was a reasonable likelihood that 2010 would go down as a flat or negative year for stocks.

Obviously the U.S. and global economies still face major challenges and problems. The overriding issue of burdensome government debt and overspending must be dealt with or the U.S. will face grave consequences. In an interview Sunday, Sen. Tom Coburn, R-Oklahoma, warned that if the government fails to deal with the problems of fiscal waste within three or four years, the U.S. economy faces apocalyptic pain.

“I think you’ll see a 15 to 18 percent unemployment rate.  I think you will see an 8 to 9 percent decline in GDP. I think you’ll see the middle class just destroyed if we don’t do this. And the people that it will harm the most will be the poorest of the poor, because we’ll print money to try to debase our currency to get out of it and what you will see is hyperinflation,” Coburn said.

While the long-term future of the economy is in doubt, right now traders and investors feel pretty good about the financial markets. In fact they feel so good that many sentiment indicators are at historic highs. For example, the Options Speculations Index is currently at its highest level in the past five years. This index compares bullish and bearish data from opening transactions on all the U.S. options exchanges and turns it into a ratio. Right now the bulls are dominating. Another sentiment indicator is the Smart Money, Dumb Money Confidence Index. Right now smart money confidence level is about 30%. The dumb money confidence level is about 80%. So the spread between the two is about 50%. All of these are at levels that normally precede market corrections. (These indicators are produced by www.sentimentrader.com.)

Sentiment indicators are generally contrarian. In other words, when they are at a bullish extreme, a market correction will usually follow. In recent weeks we have noted that based on several technical indicators, it appears that a market correction is likely early in 2011. With the confirmation of sentiment indicators, that forecast remains intact. Because of positive gains in many recent economic reports, however, it is likely that this will not be a major fundamental correction but rather a technical downturn to work off market excesses.

The chart below shows the S&P 500 over the past year. The green lines were added to show two levels where strong technical support exists. Barring unforeseen circumstances, a technical correction could well stop at one of these levels. The first is at 1,180. That is about 6% below the current level. If a correction were more significant, even stronger support is found at about 1,130 or about 10% below the S&P 500’s present mark.

Of course another possibility is that major market indices move into a sideways consolidation pattern and that no real sell-off occurs. Such a situation usually occurs when the markets are in a strong bullish trend.

From all indications, this year’s Christmas shopping season has been slightly ahead of expectations. Recent weeks have produced minor improvements in the numbers of new claims for unemployment benefits.  Earlier this month the government made a slight upward revision in third-quarter GDP. There have been minor gains in housing starts and sales. By mid January we will begin to get preliminary reports of year-end numbers for retail sales, corporate earnings etc.  If reports continue to show improvements, then stocks could defy the technical and sentiment indicators and the recent advance could continue.

In spite of all the technological advances of the past couple of decades, the ability to accurately forecast what the stock markets will do remains inexact at best. Investors seem to benefit the most when stocks can sustain a long-term trend. For 2011, avoiding the choppy markets of recent years would be a good thing.

Flint Stephens

There is not a lot of new information about the markets right now. Major market indices are still overextended by most indicators, but that does not necessarily mean that a correction is imminent. Over the next couple of weeks, however, investors need to be aware that low trading volume has the potential to increase market volatility.

Like most others, during this holiday season traders and investors want to focus on family and festivities. Many are traveling or away from the markets during the period between Christmas and New Years. A couple of weeks ago we referred to the Santa Claus rally–defined by Investopedia.com as “a surge in the price of stocks that often occurs in the week between Christmas and New Year’s Day.”

The Friday before Christmas usually shows a much higher than normal amount of trading volume. That is a triple-witching hour: the last hour of the stock market trading session on the third Friday of every March, June, September, and December. Those days mark the expiration of three kinds of securities: stock futures, stock market index options, and stock options. In December this provides an opportune time for traders and investors to get their portfolios aligned before they head off for their holiday celebrations. That is followed by unusually low trading volume from a day or two prior to Christmas and through the week between Christmas and New Years.

The chart below from December 2009 clearly shows both the traditional Santa Claus rally and the holiday trading lull. The green arrow highlights the rally and the red line on the bottom portion of the chart shows the trading slowdown.

In 2009 you can see the spike in trading volume on December 18, the last Friday before Christmas. Trading volume was nearly 500 million shares on the Dow—more than twice the average daily volume of the sessions earlier in the month. In contrast, the trading sessions immediately preceding and following the Christmas break had trading volumes of less than half the normal amount for the rest of the month leading up to the holiday.

The low trading volume usually results in uneventful trading sessions. But the low volume also means that large buy or sell orders have the potential to have a greater impact on market movement.

The most recent example was 2007. On triple-witching day, Dec. 21, 2007, The Dow rose 209 points or 1.6%. That was followed by a 190-point 1.4% decline on Dec. 27—just three trading sessions later. The 209-point rise was on trading volume of more than 430 million shares. But the drop on the 27th occurred with fewer than 146 million shares traded.

Thankfully volatile trading sessions are the exception during this holiday season. But the potential is always there. We hope that this year’s holiday market activity is uneventful and that everyone reading this has a wonderful, enjoyable and safe holiday season.

Flint Stephens

Thursday, Freddie Mac reported that the average rate on a 30-year fixed mortgage rose to 4.83 percent. Compare that to early November when the rate hit a 40-year low of 4.17 percent. It was the fifth straight week that rates on fixed mortgages rose corresponding with higher yields on long-term Treasury bonds. For those keeping score, this is exactly the opposite reaction of what Federal Reserve Chairman Ben Bernanke predicted when he announced that the Fed would begin buying Treasury bonds in a program nicknamed “QE2.”

Market analysts have noticed the discrepancy. In his weekly newsletter Frontline Thoughts, John Mauldin wrote: “Correct me if I’m wrong, but I seem to remember that one of the reasons for QE2 was to lower rates on the longer end of the U.S. yield curve. Clearly, that has not happened.”

Some experts are attributing the rise in yields to a strengthening economy, which has also kept stock markets rallying. But there are good reasons to believe that the euphoria that has driven stock prices to their highest levels in two years might be weakening.

Bullish sentiment among investors tends to be an accurate contrarian indicator. In other words, the better investors feel about stocks, the more likely it is that a correction is near. According to Investors Intelligence data the percentage of bullish investors now exceed the peak that marked the precise top of the 2010 rally in early May. From that peak, stocks swooned more than 15% in the next few months. In the past four years, the only higher peak occurred in late 2007—a peak that preceded a 50% decline in the S&P 500 Index. The spread between bullish and bearish investors is not more than 36%, according to the Institutional Investor Bullish to Bearish Survey. That is the widest margin since April 2010, prior to the already mentioned 15% drop that followed.

In his most recent weekly newsletter fund manager John P. Hussman, Ph.D., wrote: “As of last week, the Market Climate for stocks was characterized by an overvalued, overbought, overbullish, rising-yields syndrome that has historically been hostile for stocks. Clearly, we can’t observe what the outcome will be in this particular instance. We can’t rule out the possibility that investors will continue to speculate on the hope of ever larger deficits and some further combination of illegal or irresponsible Fed actions. From our standpoint, the return/risk profile of the equity market is the most negative that we ever observe historically, so we are willing to speculate neither on the hope for government wisdom, nor on the hope for government recklessness. Investors who are convinced that monetary and fiscal actions will drive the market ever higher can easily offset our hedges by establishing exposure to the S&P 500 or more speculative alternatives. What I can’t do on behalf of those investors is violate our discipline and take a speculative exposure in an environment where the historical evidence indicates an extraordinarily hostile return-to-risk tradeoff.

“Our objective remains to significantly outperform our benchmarks over the complete market cycle, with smaller periodic losses. I recognize that it has not been satisfactory simply to lose less than the S&P, but with smaller drawdowns, since the 2007 peak. Still, it would be an understatement to say this has been an unusual cycle. Given the broader set of Market Climates we have defined, I am confident that we will periodically observe more favorable market environments - possibly even in the coming months, without major changes in market valuation - where we will be able to accept risk in the expectation of positive returns. From my perspective, this is emphatically not one of them.

“It’s not pleasant to adhere to our discipline here, but I believe that it is essential to do so, because conditions like these are often where it matters most, despite the discomfort. We’ve lost several percent in … an advancing market, reflecting a tendency of investors to abandon stable investments in preference for the ‘risk trade’ in highly cyclical stocks, as well as option time decay in an environment where defense is seen as unnecessary. The market’s recent embrace of the ‘risk trade’ can be traced to the apparent endorsement of risk-taking by the Fed. Still, it’s wise to remember that while Fed Chairmen have proven to be apt encouragers of bubbles over the short term, the ‘Greenspan put’ certainly didn’t avoid the 2000-2002 mauling, nor did the ‘Bernanke put’ avoid the even deeper 2007-2009 plunge. The only put options that investors can rely on here are the contractual kind.”

Of course we all know that stocks have staged an impressive rally since bottoming in March 2009.  But even with those gains, the index is still significantly below its 2007 high. You can see what I mean by looking at the accompanying chart. The area highlighted by the light blue rectangle shows the ground that the index still has to cover just to get back to where it was at its 2007 peak.  In other words, an investor who got out of the market at the peak and parked his money in a non-interest bearing account would still be significantly ahead of someone who has been fully invested in the index during this period.

I’ve added a couple other features to this chart to help clarify the current situation. The green arrow highlights the point where the S&P 500 Index made it back to the 1,100 level following the March 2009 bottom. As you can see, it reached that point in seven months. Since bottoming in March 2010, the majority of the S&P 500’s gains occurred in that seven-month period. The pink line also highlights the 1,100 mark because since reaching that level, the index has hovered in that vicinity for many months. It was below that point as recently as October 2010.

In contrast to the steady rise that carried stocks through the seven months that began in March 2009, this year stocks have seen both upward and downward volatility. Major indices are showing nice gains for 2010, but it has not been a smooth ride.

Hindsight is perfect and as stocks have risen we erred on the side of caution. U.S. and world economies remain fragile. Although the market still has positive momentum, we believe that right now risk levels are high. We have learned through the years that when it comes to the long-term health of one’s portfolio, avoiding major market meltdowns is more important than participating in every rally. We underestimated the strength of the most recent market advance. But jumping in now would undoubtedly be the wrong move.

Let me again quote from John Mauldin’s most recent newsletter: “We can look back now and see where we made mistakes in the recent crisis. We actually believed that this time was different, that we had better financial instruments, smarter regulators, and were so, well, modern. Times were different. We knew how to deal with leverage. Borrowing against your home was a good thing. Housing values would always go up. Etc.

“Now there are bullish voices telling us that things are headed back to normal. Mainstream forecasts for GDP growth next year (2011) are quite robust, north of 3.5-4% for the year, based on evidence from past recoveries. However, the underlying fundamentals of a banking crisis are far different from those of a typical business-cycle recession. … It typically takes years to work off excess leverage in a banking crisis, with unemployment often rising for 4 years running.”

Given the strength of stocks over the past few weeks and economic numbers that have shown improvement, the next correction is unlikely to be of the type we endured in 2008. But from the current level, it would not be surprising to see the S&P 500 pull back to that 1,100 mark again. It might even drop back to its September 2010 low, which would be about 1,050 or 15% below the current level.

This correction that we expect could begin next week, or it might not start until a month or two into 2011. But taking a position in stocks right now could easily turn out to be a painful mistake.
Flint Stephens

This week the financial news media heralded the fact that the S&P 500 reached a new high for 2010. While that sounds like good news for stocks, the reality is that the current rally is overextended and living on borrowed time.  Based on several technical indicators, the prospect of a fairly significant correction is high. But there are solid reasons to believe that any major correction will not occur until after the New Year.

Stocks began a pullback in early November. That slide was basically erased in two days at the start of December when President Obama said he was willing to reinstate the tax cuts that were set to expire at the end of this year. Wall Street essentially ignored a November increase in unemployment and a dismal jobs report in its enthusiasm for renewed tax cuts.  But that euphoria could lose its luster in the New Year as investors and traders realize that extending the Bush tax cuts merely maintains the status quo and does nothing to stimulate new job growth.

The accompanying chart shows how the S&P 500 fared over the past year and the current situation. While this index is at a new high for 2010, current levels are only slightly above where they were at the April peak and again in early November. The gold line is a 50-day simple moving average (MA). Notice that during the November drop, the index reached its MA and then bounced back upward.

The first indicator below the top portion of the chart is a relative strength index (RSI). When the RSI is trending above 50, an investment has enough momentum to sustain an advance. If the RSI approaches 80, that is an overbought level and a downturn is likely. In November the RSI touched 80 and fell quickly below 50 when the S&P 500 corrected. Right now it is again above 50 but well below 80, indicating a possibility for the index to add to its gains.

The middle indicator is a moving average convergence divergence (MACD). This indicator also reversed and turned positive at the beginning of December. It is rising, but has not yet reached a highly overbought level. So this provides additional confirmation that the S&P 500 could continue to rise.

The bottom indicator is a stochastic oscillator. It reached an overbought level and turned negative a few days ago. But since early September, this indicator has only completed one full downward cycle. In several other instances it reversed and turned positive before the S&P 500 reached an oversold level. So it is likely that it could do the same in this instance.

Seasonal factors are also at work to stifle a major correction in December. Most investors are familiar with the phenomenon of the Santa Claus rally. The Investopedia.com web site defines the Santa Claus rally as “a surge in the price of stocks that often occurs in the week between Christmas and New Year’s Day. There are numerous explanations for the Santa Claus Rally phenomenon, including tax considerations, happiness around Wall Street, people investing their Christmas bonuses and the fact that the pessimists are usually on vacation this week.”

Other factors bolstering stocks at this season are difficult to measure, but their existence is real. For example, mutual fund managers, hedge fund managers, pension fund managers, investment advisors, bank executives and virtually everyone else involved in investing or finance is judged based on calendar-year performance. Many of these market movers receive significant compensation and bonuses if their account balances show gains at the end of the year. These people are going to use whatever power is at their disposal to avoid a big correction between now and the end of December.

Politicians in Washington D.C. also want the stock market to end the year strong. While the National Bureau of Economic Research and Washington economists measure recessions by GDP growth, many ordinary citizens judge the economy by their investment portfolio and 401k balances. While the Republicans scored the most wins in the recently completed November elections, the results should have given pause to anyone in Washington politics no matter their party affiliation. Many Americans are angry and hurting. Economic victories are desperately needed to quell public frustration and distrust. Big market losses right now would likely lead to more outrage directed toward the nation’s capitol.

Washington politics is also the wild card that has the potential to send the market plunging before 2011. If members of Congress are unable to reach a consensus on a tax cut extension before they break for the holidays, there could be a precipitous decline in stock values. Wall Street does not like uncertainty and failure to approve an extension would cause lots of headaches for businesses and individuals that would need to make substantial changes in the financial planning to deal with expiration of the tax cut.

Mutual fund owners need not panic

December can cause needless worry for people who track the daily pricing of mutual funds in their investment accounts. Prices for many funds will experience significant one-day drops this month as yields and dividends on underlying investments within the funds are paid to owners as phantom distributions. For example, this week the price of Pimco Total Return Fund (PTTRX) dropped more than 5% in a single day. That is a hefty move for a low volatility fund that rarely moves more than a few cents in any session.

By checking their overall account balance, investors who own PTTRX should have seen a corresponding increase in the number of shares they owned. In other words, while the price per share declined, the total value of an individual investors account should remain the same.

In tax deferred qualified accounts like IRAs, 401ks, variable annuities, etc., these phantom distributions have no real impact on an investment portfolio. In non-qualified accounts, however, the IRS views these just like dividends paid by stocks and they are taxable events even though there is no change in the account balance.

Flint Stephens

With less than a month to go before the end of the trading year, the race between stocks and bonds is nearly a dead heat. The chart below shows three investments: The New York Stock Exchange Composite (NYSE), Long-term U.S. Treasury bonds (TLT) and Pimco Total Return Fund (PTTRX).  PTTRX is among the world’s largest funds and invests primarily in shorter-term investment grade bonds. Since spring, Strategis has held positions in long-term bonds and in PTTRX.

It is clear to see that while there has been movement in both stocks and bonds in 2010, sustained trends have been lacking. Most moves of significance have lasted less than 60 days making them difficult to trade.

While the past month produced both big up days and big down days in stocks and in bonds, the net effect has generally been sideways. A month ago technical indicators were showing that stocks were overbought and bonds were oversold. Today those conditions have moderated and both investment categories are currently mid-range—neither overbought nor oversold.

What this all boils down to is that with a month to go in the trading year, it is difficult for anyone to accurately forecast where the financial markets will end 2010. To add to the uncertainly, Congress is still bickering over an extension of the Bush tax cuts, unemployment remains a huge issue and the European debt crisis might be reaching a critical level. Wall Street does not like uncertainty and right now plenty of uncertainty exists.

On the other hand, Wall Street also does not like to end the year in the red. Bonuses for money managers are based on calendar year performance. So for this final month, Wall Street executives are going to be doing everything in their power to make certain that there is no big sell-off. Day-to-day volatility is likely to continue through the remainder of the year in response to announcements about economic data. But unless there is some unforeseen major economic event, it would not be surprising to see the financial markets end the year close to where they currently are.