In many issues of my weekly newsletter EPIC Insights, I have dedicated a great amount of space to describing how to interpret a market's reaction to news. According to the academics, a stock's price accurately reflects all known information. Therefore, only new, unexpected data can swing prices. If this theory were true, good news would move prices higher, bad news would push prices lower, and the absence of news would leave prices unchanged.
As those of us who operate in the markets know, this plain vanilla approach is lacking. Rather than focus on what the news says, I have always believed we should watch the market's reaction to it. When good news moves prices higher we are unimpressed. When bad news moves prices higher bullish principles are at work.
Last week offered an occasion when the lack of news drove prices skyward. Over a shortened four-day week, the Dow rose 1.9% in relentless fashion. With the largest daily gain at 0.8%, the market moved steadily higher in spite of a lack of new information to ignite the move. Instead, investors became progressively more bullish in a disciplined fashion.
The question we now ask ourselves is if last week's rally is a change in investors' desire to own stocks, a move anticipating good news, or an unsustainable move that will be reversed. Luckily we will not have to wait long for the answer. Also, while last week was devoid of new information, this week is jammed tight. Therefore, if the move was a rally anticipating better information, we shall receive that information soon.
While I was early to indicate the trend was higher, I was also one of the few to discuss the fragility of the rally. Overall stocks are not cheap, and the economic environment, although improving, remains weak. Accounting for these difficulties, what remains is a market driven by emotion and technically bullish patterns. Having isolated this as the driving factor for the current rally allows us to watch it for changes.
Last week, a number of stocks and indices carved out top reversals which may have offered the first signs of a topping process. Following a small bounce Monday and positively received economic reports, we are in process of resuming the rally. Therefore, what initially appeared to be a top last week is now viewed as a consolidation in an ongoing move higher.
For now, the market believes a swift recovery will follow the recession and corporate earnings will quickly rebound. Were both to occur, the overall environment would be supportive of stocks and the fundamentals would improve. I believe the consensus is wrong. Prior robust recoveries were driven by credit expansion-a benefit this recovery will not posses. Therefore, I expect the current recovery to be mild, fragile, and uneven.
With such an expectation, we will watch the technicals for market direction. When the market eventually breaks down, it will indicate that a liquidity fueled rally has run its course. At that time, investors should reduce risk and await a pullback.
Although the future outcome is predictable, the timing and path taken are not. For now, the trend is clearly bullish and we are best served by owning stocks. However, the turn will be abrupt and only those closely monitoring their portfolios will prosper. When prices peak, head for shelter. Until then, enjoy the ride.