Under the Hood: A Closer Look at the Current Market Rally

Many investors over the last year unfortunately have been exposed to huge losses in their portfolios and may be sitting on the sidelines trying to figure out the proper time to get back into the stock market. In highly volatile, news-driven markets it can be challenging to know the right time to re-invest. Deciphering the huge amount of economic data, interpreting the news media, and the evaluating opinions from talking heads on TV is often very daunting. Considering the sea-change occurring with government policy and the unprecedented intervention to invigorate the economy, it’s hard to gain clarity on the market’s current rebound. Many are conjecturing if this is a Bear Market Rally or the start of a new Bull Market. The truth is it’s best to let the market tell you how strong the rally is, and, if at all possible, monitor its technical condition day by day just as a doctor would monitor a patient under his or her care.

Dr. Van K Tharp, a respected trading psychologist, often describes human limitations with prediction along with our tendencies to have an "authority bias" as some of the many reasons investors have trouble making money in the markets. A new field of study called behavioral finance attempts to predict changes in the market by studying the inefficiencies of human decision making. The value in understanding these judgmental heuristics comes from developing strategies to neutralize how they may impair you and your decision making. When your judgments no longer impair you, there is a higher probability to increase the returns and minimize the drawdowns in your portfolio. For example, it may be better to not get caught up over intellectualizing the vast amount of economic data reported every market day. I've often thought if I had the results of all of the economic reports in advance, that data would still probably be untradeable. Is the loss of 650k jobs and an unemployment rate of 8.5% good or bad? It doesn't sound too good, but what if the "consensus" expectations are much worse?

Perhaps the best way to gauge the health of the markets is to study and monitor its technical condition day by day.

Some things to look for:

• Volume - is the market volume heavier on down days or up days?

• Breadth - what are the market internals telling us (advancing issues vs. declining issues, advancing volume vs. declining volume)? Are the indices rising with more or less individual stock participation?

• Depth - Is the rally broadening out to various industry groups or is it mostly short covering of the highly beaten down stocks and sectors?

• Leadership - are more leaders breaking out during rallies? Bull markets are usually led by technology and small cap stocks. Where are the current leaders coming from?

Back in March of 2003 it took several months for leading stocks to finish forming their "basing" technical patterns for a justifiable low risk-to-reward buy. It is always important to know which stocks are the leaders and closely monitor how these leaders act on both up and down days.

I highly recommend you take a historical model and perspective and apply this to your decision making. This first chart below is remarkable in terms of how the Nasdaq, leading up to the 2000 blow off top, is in a similar position and compares to the Dow Jones 1929 boom and bust. The red line is a twenty year period for the Nasdaq monthly closes beginning in 1992 through March 2009 and the blue line is the Dow index from 1922 and beyond the 20 years of monthly closes extending out to 1946. Both indexes are simply indexed to 100 for comparative purposes. This is not to suggest that the Nasdaq will continue to track the Dow exactly, but there are several important takeaways from this chart. The Nasdaq and Dow have really followed each other like twins since these long term peaks and valleys. The Dow and the Nasdaq both bottomed in 1932 and 2002 respectively and began a sustainable bull market rally lasting six years. Both markets crashed again in approximately one year or a very short period of time and the Nasdaq is currently in the very initial stages of attempted rally. Our red line stops where we are now in April 2009. If we look at the Dow there was a 60% rally from this respective point — which may suggest there may be 30% or so further upside to the current run. It will not be straight up and these monthly data points do not show areas of brief consolidation or pullbacks.

After several years of more sideways action, the Dow pulled back and corrected back to its prior lows in 1942, which was then followed by another huge rally. Whether the Nasdaq continues to follow this in as close similarity remains to be seen. The stock market tends to be an emotional roller coaster. The parade of fear, hope and greed never changes. If you look at the technical patterns of the early leading stocks in the 20’s 30’s and 40’s in Steels, Railroads, Automobiles, one can build models to look for similar repetitive patterns which apply to the market today.

Let’s dig a little deeper and see if we can draw any other conclusions from the current investment environment.

Our next chart shows a lagging IBD 100 leading stock index below the green line of the broader S&P. This is a bit troublesome as it would suggest that leading stocks are lagging the recent bungee jump rally and may need a month or two to finish forming their basing patterns for a more optimal entry. For those not familiar with the IBD 100 index I have found it to be valuable because it is based on potentially strong stocks with respectable fundamental and technical characteristics. In my career I have never seen a strong sustainable rally occur without this index showing some degree of out-performance. With that said, one would be ill advised to just blindly buy all stocks in the index without some serious time devoted to studying these companies individually.

In the current rally it can be said that leadership remains sloppy and slow to emerge. Most stocks showing leadership have flaws. There are a number of sloppy bases with flawed fundamentals. Much of this is due to the state of a terrible bear market condition.

Those are some negatives to consider. However, with that said, the current environment is better (or less bad?) than it has been for the past year. One potential scenario going forward is a series of tradable rallies followed by deep retracements in the next several years.

From this recent market low we are seeing more leaders beginning to break out. When the market has its down day’s, leaders are hanging in there — generally pulling back on lighter volume. Our approach is to conduct a couple of buys and see how they act and cautiously move with the market and not be "100% in" at the drop of the hat. Currently, our fund has allocated 30% to long trades. If the rally is real, we will have ample opportunities to scale into more positions at optimal entry points. We will be patient and let the leadership guide our moves. I hope you do too.

Michael Doran is Managing Director of the long/short equity fund, Emerald Bay Partners LP. Mr. Doran can be reached at (530) 677-1635 or mdoran@sierrainvestor.com

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