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Why the Market Does What it Does (& What It Will Do Next)

The S&P 500 managed to gain 4.5% last week, overcoming a big Wednesday pullback, and more than offsetting the previous week’s 1.2% loss.

So what happened in the meantime to turn investors back on again? Economy? No, the new unemployment claims figure is back in the ‘too high’ area, and real estate appears to be crumbling again. Good earnings news? No. Though we saw plenty of encouraging surprises, we saw a fair number of letdowns too, from Yahoo, Google, and others. (In terms of beats/misses, this earnings season is about the same as all the rest.) Cheaper oil? No, if anything, the brewing storm in the gulf is going to tighten the supply for a few days, and push prices higher. Confidence in the federal government? No, Obama’s polling at near-record unpopularity, and the bulk of his decisions are considered ‘business unfriendly’.

So what gives? Here’s why the market rallied so well last week, and for that matter, why it’s up 8.8% over the last three weeks….. because investors were just ready to buy, choosing to see more value in stocks than liability.

Don’t laugh - it’s the truth. Nothing else that is ’supposed to’ drive stock prices changed during that time. Investors just decided it was time for a rally.

Some of you will believe that, some of you won’t, and some of you will consider the idea over time before making a decision. Whatever group you fall into though, you should also stew on something not that we said, but something Benjamin Graham (the founding father of the “why the market does what it does” theories) wrote long ago….

In the short-term, stocks are a voting machine and in the long-term, stocks are a weighing machine.

The short-term ‘votes’ are swayed by the ebb and flow between fear and greed. Since they are always changing though (largely due to factors that actually have little effect on the market), stocks are rarely pointed in the same direction for very long.

What being ‘weighed’ in the long-term is earnings. Eventually, even if only temporarily, stocks are valued appropriately. This may only occur a few times per year, if that, but it’s why long-term ‘buy and hold’ investors are willing to hang on, even when the environment is testing their confidence.

Or to put all of this succinctly, the April/June pullback was the result of overbaked bearishness (fear), which stemmed from excessive confidence (greed) that swelled up in February and March.

Undoubtedly we’ll see greed/confidence peak again in the foreseeable future, at which time stocks will be back to an overvalued status. Guess what’s going to happen then…. another pullback.

All those up and down swings? Those are the ‘votes’ Graham was talking about. With each of those swings, however, the S&P 500 has or will hit the 1150-ish area, which - based on earnings - is what we see as an appropriate valuation for the broad market. Even if it’s only there for a short time, getting there at all validates Graham’s idea that over the long haul, the market does get it right.

Yes, the earnings outlook is always changing, but never to the degree that all these wild swings in stock values imply. True earnings-based investors only need to look at the market and the earnings data on a weekly basis, and really, a mere monthly view may be adequate. All the gyration in the meantime is just a lot of fluff and volatility, mostly induced by the media that preaches a ‘take action now’ mentality for with every shred of news.

We’ve said this before, but in light of everything discussed above, we’ll repeat our important message today - investors who can distinguish between long-term trends and short-term trends, and trade accordingly, are equipped to outperform amateurs and professionals alike. That’s why we focus so much on our short-term timing tools like breadth and depth, and continually look at the market’s overall P/E ratio.

Anyway, as far as the market is concerned….

Given the current bullish momentum, and the growing degree of optimism because of the recent gain, we’re looking for stocks to continue upward. In an ironic twist though, by the time the S&P 500 reaches levels that are high enough to convince everyone that the market is in a recovery mode, the index will also hit a couple of major headwinds.

The first headwind is the potential resistance at the 200-day moving average line (green), currently at 1113.

The second headwind is the upper 50-day Bollinger band, currently at 1140, but falling. By the time the S&P 500 hits the 200-day average line’s area around 1113 though, that Bollinger band may be right there too. (Bear in mind these potential ceilings are rarely exact ceilings - we want to watch closely anytime the indices are around major milestones.)

While Bollinger band are generally not part of our normal technical fare, they’ve proven to be reversal points for almost all the major trends since March of last year, or at least the guideposts in cases where a reversal did not immediately materialize. You can see this so some degree on the nearby chart, but to really appreciate how important these band lines have been over the last year and a half, check out this full-screen chart.

To be clear, we’re not saying the market’s going to rollover around the 1113-ish area; we’re just watching for it here, as if it’s going to happen at all, that’s the most likely pace for it to happen.

Indeed, if we had to venture a guess, based on momentum and earnings, we’d expect a brief pause there, and then look for the S&P 500 to gently push the upper band higher. It would be quite like the progress seen in November and March.

Let’s cross that bridge when we come to it though.

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James Brumley is a freelance writer and registered investment advisor. He began his career as a broker with a major Wall Street firm, where fundamentals and long-term holding periods were core strategies. After that, he switched gears completely, becoming an analyst at a short-term trading newsletter that focused on technical analysis. He now manages client money using the best of both philosophies. His company, Bluegrass Portfolio Management, offers investors an opportunity to reap superior returns with minimized risk.