Which Way Will the Market Go?

 | Sep 15, 2011 | 11:30 AM EDT  | Comments
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In this ridiculous and super sensitive tape, it's only natural to hunt for clues that the market has it all wrong and things are not as bad as they seem.

With improved domestic economic conditions and reasonable sales and earnings from European companies in the third and fourth quarters, the bull market that began in March 2009 could resume. This year there have been three corrections (but for less than the 15% characteristic of a bear market). Let's look at some stats from those corrections:

• The average decline from peak to trough was 8.4%.

• The rally from troughs each time was shorter in duration.

• Percentage declines from peak to trough have increased in magnitude.

At each point of selling exhaustion, valuations were deemed too compelling for investors to disregard and ground lost in the markets was regained. Unlike other rallies, which were rooted in valuation calls, it will be difficult for that line of reasoning to materialize currently as valuations are being tossed aside due to widespread fear, which causes tight sector correlations. In this regard, the tape almost resembles the highly correlated one that ensued as Lehman Brothers was entering the grave.

An area of interest for me when the market appears oversold and begins to rally a little is to observe the performances of the Russell 2000 small-cap index and the Dow Transportation Average. The reason is simple: smaller domestic firms may have demand and profits that are not falling into an abyss, so orders at transport companies trickle in better than the headlines imply. The market's forward-looking mechanism anticipates these macro features and sends each less talked about (but no less important) index higher in advance.

Dividend-paying multinationals have been all the rage since the market began to catch a cold in early July. I have zero qualms with dividend-paying multinationals as investments in this climate. With stock prices generally not packing a punch, an investor could still capture a nice quarterly dividend stream. Unlike 2008-2009, the cleansing of toxic waste from corporate balance sheets has made these dividend payments not only safe, but they are poised for hikes.

Yet, from the Aug. 9 intraday low in the markets, it has been the generally non-dividend paying small-caps that have outperformed and, by extension, the Dow Transportation Average.  The performance mirrors what happened from June 16 to July 7, which represents the last rally from a trough.

Aug. 9 to Sept. 14:

• Russell 2000: +8.13%

• Dow Jones Transportation Average: +7.2%

• Dow Jones Industrial Average: +4.7%

• S&P 500: +6.2%

June 16 to July 7:

• Russell 2000: +11%

• Dow Jones Transportation Average: +11.1%

• Dow Jones Industrial Average: +7.2%

• S&P 500: +6.18%

March 16 to May 2 :

• Russell 2000: +9.7%

• Dow Jones Transportation Average: +9.7%

• Dow Jones Industrial Average: +10.8%

• S&P 500: +8.96%

Is this connection between the Russell 2000 and Dow Transportation Average a clue that you could put on longs and go shopping for a Halloween costume? (Michael Knight from Knight Rider is my favorite.) Let's not get carried away. The clue is that moves must be met with skepticism (the June-to-July advance was a head fake and shorter in duration relative to other rallies this year) until there is macro data that support the hypothesis that the market has priced in dreary earnings outcomes. Any sniff of a European Union resolution would also be welcome news.

Above all, patterns in the indices this year underscore the necessity to actively manage your portfolio and have the confidence to shift asset allocations and the risk profile upon development of a new short-term macro trend.

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