GETTING TECHNICAL
As Risk Builds, Investors Still Sipping New Year's Champagne
By MICHAEL KAHN
The new year started on the high left over from the old year. But how long can the hangover be averted?
WHAT DO YOU CALL IT WHEN stock prices crawl higher, investors are mostly absent and traders are barely trading? A rally.
It can't be denied that the trend is still up. The question is not whether the stock market is rising but how long it can keep it up. Like any pendulum, the further it swings away from equilibrium in one direction the further is will swing the other way.
In other words, when the zero interest-rate environment and government supports are removed, the market could cleanse itself in a hurry.
I do not say this based on assumptions of a double dip in the economy or the dollar falling into the abyss. Rather, it is an acknowledgement that the market, when it is finally allowed to be free again, will do what it is supposed to do to wring out the excesses built up during any bull market.
And just what are those excesses?
For starters, it seems that "everyone" is assuming stock prices will continue their march higher. Sentiment indicators, such as the Investors Intelligence poll, show stock-market optimism at levels not seen since just before the market peaked in October 2007. And the Standard & Poor's 500 is still 28% below its peak level at that time.
Logically, seeing a portfolio down 28% after two-plus years should make investors despondent, not glad. But investors are driven by emotion, not logic right now, and the prevailing view is bordering on giddy.
Another excess is the size of the rally itself from March. With the S&P 500 up an astounding 70% in nine months, even nontechnically oriented investors must admit that prices have moved too far, too fast.
Chart historians will point to past moves to show precedent for such a huge recovery following a bear market. For example, after the bear market of 1973-74, the market recovered 78% of its loss before its next major decline (see Chart 1). But it took 23 months, not nine, to do it.
Chart 1
In other words, the market moved more than twice as fast in 2009 as it did in the 1970s, and that leaves it vulnerable to a serious correction.
Many fundamental-analysis pundits look for the current rally to continue until a major correction sets in during the second half of 2010. It is possible to reconcile this view with the charts because sentiment and momentum analyses can always stretch further than they are right now. They cannot give us market timing, only background.
But eventually, the market, like a rubber band stretched too tightly, will snap back. Whether next week or next July, we cannot know, but if you are already in the market or looking to get in, understanding and controlling risk are paramount.
Traders may use hard stop-loss orders. Investors may simply wait until the trend changes (see Chart 2).
Chart 2
It looked like it was about to change in October, but the bulls were not done. Prices rebounded off their rising bull-market trendline quite nicely. And while the rally has been rather anemic over the past two weeks, that trend remains intact.
A drop down to 1075 on the S&P 500 would be a good signal that the trend has changed for the worse. That is just a few points below the bottom of the November-December trading range and would be more than a 50% retracement of the current leg up from the October low.
Until that time, bears have to be patient.
Michael Kahn, mutual fund co-manager, author of three books on technical analysis, former Chief Technical Analyst for BridgeNews and former director for the Market Technicians Association, also blogs at www.quicktakespro.com/blog.
Copyright 2009 Dow Jones & Company, Inc. All Rights Reserved
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