Recipe for a Market Rally

According to the National Weather Service, in order for a winter storm to qualify as a blizzard it must have: 1) large amounts of falling/blowing snow, 2) winds in excess of 35 MPH, and 3) visibility of less than 1/4 of a mile for at least three hours. Similarly, in the market there are certain conditions that must be present to create a sustained and powerful rally. By analyzing the conditions present at the beginning of the market's most recent uptrend, we can identify certain factors that produce a fertile environment for stock picking. Just like in a blizzard, any one of the following conditions in isolation would be insufficient; it is only when these factors combine that we can experience a nice rally. With that said, let's take a trip back to September, with the inception of the second leg of the bull market that began in March 2009...

Strong Bearish Sentiment
As the month of September began, pessimism abounded and bulls were scarce. Who could blame them? The Dow dropped nearly 1,000 points in a single day only a few months earlier, causing household names such as Procter & Gamble to plummet in gut-wrenching fashion. The summer featured multiple fake-out rallies, enough to draw in optimistic investors and then slam them with a harsh market sell-off. SPX 1040 was the level of lore, as many anticipated that a breach of that level would lead to a potential retrace back to the inverted head-and-shoulders neckline of 950 that was pierced in the Summer of 2009. The market hung on the edge of a cliff, as employment reports and housing statistics indicated the economy wasn't improving as much as investors hoped -- if at all. To quantify the extreme bearishness, the American Association of Individual Investors reported on September 2nd that bullish sentiment stood at 30.8% versus 42.2% bearish sentiment. As a reference point, the long-term average for each is 39% bullish and 30% bearish, basically inverse the current readings. This negativity appeared not only in sentiment surveys, but in investors' actions as well: August witnessed the withdrawal of over $14 billion in domestic equity funds. The public's disdain for the market was palpable, creating the first condition needed for an overall market rally.

Institutional Accumulation
Boom. When the masses expected the market to continue its precipitous and sickening decline, institutional investors stepped up to the plate, and did so in a major way. On September 1st, the market followed through on an attempted rally that occurred on August 25th. For the day, the SPX closed up 31 points, or 2.9%, on volume that was 29% higher than the previous day. Hedge funds and mutual funds reached for their favorite stocks like fat kids reach for cake, sending AAPL up 7 points, BIDU up 3, PCLN up 15, and NFLX up 9. It would only be a sign of things to come. The market never experienced a cluster of distribution days (drops of at least .2% on increased volume) within a short period of time, demonstrating that the big boys were holding shares and in no rush to dump their positions. In contrast, the period between April 16th and May 4th witnessed five distribution days, an ominous sign that ultimately led to a choppy summer.

Broad-based Leadership from Various Sectors
An impressive aspect of the market's most recent rally is that the uptrend wasn't contained within a couple different industries. Instead, stocks from sectors as different as silver miners (SLW) and shoe manufacturers (DECK) saw explosive rallies. Commodities (FCX, BTU, RIG) saw higher prices as the Federal Reserve's effort to devalue the US Dollar made everything from copper to oil increase in value. As Ben Bernanke's crew made it clear they would keep rates low for an extended period to get the economy back on track, industrials (CAT, DE, PH, HON) rallied hard. Companies catering to the wealthy consumer (JWN, TIF, RL) experienced major uptrends, as a rallying stock market resulted in an uptick in consumer confidence. Even shares of discount retailers (DLTR, FDO) were snatched up, as unemployment remained stubbornly high and many shoppers continued to seek out bargains. Technology companies specializing in cloud computing (RAX, FFIV, CRM) witnessed explosive moves, as corporations looked to become more efficient while boosting the speed of their networks. The rails (UNP, CSX, NSC) showed tremendous relative strength, as China and other developing countries continued to gobble up everything from coal to grains, and railroads facilitated the transportation process. Even the fertilizer stocks (POT, AGU, MOS, CF), once left for dead after the euphoria that was the Summer of '08, were buoyed by takeover attempts and elevated grain prices that boosted farmers' incomes. Sure, the financials mostly sat out of the fun, but other sectors more than picked up the slack.

So where do we stand now? The most recent sentiment survey by AAII reports that 55.88% of participants are bullish, while only 18.25% are bearish. The week ended December 21st saw the first positive US equity fund flows since April, as the recent rally has brought back the retail investor. Compare these data points to the pessimism and risk aversion witnessed at the end of August/beginning of September, and we clearly no longer have the overwhelming element of bearishness to propel the market higher. That said, the short interest in many leading stocks remains elevated, and everyone and their brother seems to think the vast amount of debt racked up by the US government will lead to complete ruin on par with the sun no longer shining. Suffice it to say that although some may remain bearish, the majority of market participants see this market continuing to grind higher. The institutions seem to be in no rush to flee from stocks, as down days have been scarce and every dip (see Friday, 1/7/11) seems to get bought up. The SPX remains well above both the 20 and 50-day moving averages, and both should provide support upon any potential test. Leadership is a mixed bag; for example, BIDU, arguably the strongest of leaders throughout this rally, showed signs of weakness lately, as it pierced the 50-day moving average in mid-December on nearly double the average volume. Another leadership stock, NFLX, has recently seen its 20-day moving average slope downwards, an event that hasn't occurred since August. MCD and KO, which provided leadership in the consumer defensive area, saw some nasty price action in the past couple of weeks, but this may simply be a rotation to more economically-sensitive names. Despite these potential cracks in the armor, breakouts from leading stocks are still happening, an encouraging sign for bulls. Just last week, PCLN broke out of its base on more than double the average volume, and OPEN surged to all-time highs as well. The financials, which lay dormant during the summer, have rallied of late, evidenced by JPM finally cracking 42 to the upside. Even older, more established tech stocks such as IBM and JNPR have shown encouraging price action of late. Leadership appears mostly intact, although it may have switched to different stocks. Should we see institutions fail to support their favorite names, in combination with a cluster of high volume down days on the major indicies, it may be time to leave the party that began last September. Until then, keep riding the trend, which points decidedly higher.