Global bull market may soon face biggest test

April 16, 2011, 8:40 a.m. EDT

Global bull market may soon face biggest test

Commentary: A larger correction may be coming[i]

By Howard Gold

NEW YORK (MarketWatch) — After two years of rallies and only one major correction, the global bull market may soon face its biggest test.

The impending end of the Federal Reserve’s latest easy money program (“quantitative easing” or QE2), along with seasonal weakness in stock markets and other events, could cause investors to doubt this bull once again. Watch video “Experts Explain: What is Quantitative Easing?”

The potential turbulence could resolve the big question that has been hanging over the markets: Is a real, sustainable economic recovery driving stock prices higher or, as the bears claim, is it just an illusion pumped up by excess liquidity, especially from the U.S. government’s printing press?

Meanwhile, earnings season is upon us. The way stocks react to the good news we’ll probably hear will tell us which way the market will go in the months ahead.

And some key technical indicators are at major resistance points. If they don’t break through them, then we might want to follow Mark Hulbert’s recent advice to “sell in April and go away” — at least for a while. Read Mark Hulbert’s column on getting a head start on summer weakness.

But let’s look at the fundamentals first.

More than a year and a half after the official “end” of the 2007-2009 recession, the U.S. economy is recovering, albeit more slowly than usual. There were 216,000 new jobs in March — the most recent of several encouraging employment reports — and private-sector job growth in particular has picked up.

U.S. exports set a record in January, riding the demand from China and other emerging markets for manufactured goods and food. That has helped multinational companies in the Standard & Poor’s 500 index /quotes/comstock/21z!i1:in\x SPX +0.39% clock huge profit gains and hoard over $2 trillion in cash.

S&P 500 companies’ earnings have topped analysts’ estimates for seven straight quarters, and in the fourth quarter of 2010, more U.S. companies beat Wall Street’s revenue growth forecasts than at any time in four years.

Companies are raising dividends again, stock buyback authorizations are up nearly 40% from last year, and the US initial public offering market is off to its best start in years.

All of these things, I believe, will support a better market as the year goes on. But first there are some hurdles to clear.

The biggest, of course, is the imminent conclusion of QE2. By the time the program winds down in June — and it won’t end early, that’s for sure — the central bank will have bought $600 billion in additional Treasury securities as part of its plan to support what looked like a much weaker economy last year.

I don’t know if it’s worked or not, but in the ensuing months measures of consumer and business confidence have risen. (They’ve slipped again, however, in the wake of the Libyan uprising and Japanese earthquake, tsunami and nuclear accident.)

Stock and commodity prices have soared, too, although I believe the impact of QE2 has been exaggerated here: The broad measure of the money supply, M2, has risen by only 2.4% this year, and the extra money the Fed has pumped in is only about 1% of global gross domestic product in 2010.

What the end of QE2 portends

Still-strong growth in emerging markets like China, India, and Indonesia have driven demand for commodities much higher, and their growing surpluses also have added to the flood of money washing around the globe.

But oil and commodities prices have eased recently from their recent highs, and I think that might keep inflation from taking off over the next few months.

So, when QE2 ends, I’m not looking for the end of the world, or even the end of the recovery — just some slowing for a quarter or two. Once investors see that, a lot of the fear looming over that event will dissipate.

Surely more good earnings won’t be enough to dispel the continuing anxiety. After several quarters of shoot-the-lights-out earnings gains, the first quarter should show a more sedate 12% or so advance — good by any standard other than the ones we’ve gotten used to recently.

Meanwhile, the calendar is starting to work against us: From May to October, stocks historically perform worse than they do the other six months of the year, and we’re entering those dog days soon.

But the presidential election cycle, which gave us such a great boost over the past few months, may also start to fade.

True, the third year of the four-year cycle is the best, averaging 17% annual gains since 1945, according to Sam Stovall, chief investment strategist at S&P Equity Research. But the best three quarters of the whole cycle are the fourth quarter of the second year and the first two quarters of the third year. Read Howard Gold’s take on the presidential election cycle and other catalysts on MoneyShow.com.

We’ve just begun the second quarter of the third year, but the rally started last Aug. 27, before last year’s fourth quarter officially began. In the nearly six months between then and its February peak, the S&P rose 28%.

And lately, the market has looked just plain tired. The S&P 500 hit its recent high of 1,343 on Feb. 18, nearly two months ago. The sell-off after Libya and Japan drove the S&P down 6.5%, but it has not topped the previous high yet on the rebound.

This is critical, as technicians see significant overhead resistance at around 1,345, and support around 1,300 to 1,315, where it hovered this week.

The S&P needs to break decisively through that 1,345 resistance for the bull to make its next big move.

Another crucial barometer: the Russell 2000 Index /quotes/comstock/64a!i:rut RUT +0.91% of small-capitalization stocks. It recently came within a hair of its June 2007 record high of 855.18 and even topped that during daily trading. But it has never closed above it.
In the wake of the correction

As I wrote in January, U.S. small- and mid-cap stocks have been the “sweet spot” of the global market rally. Read Howard Gold’s commentary on why smaller stocks have done well on MoneyShow.com.

With the “risk-on” rebound since March, they reassumed leadership. But if they can’t top the 2007 all-time high now, they may have to pass the baton during the next big move.

So, in the months ahead, we may see a bigger correction than we had earlier this year, perhaps even approaching last year’s Greece-induced 16% selloff, especially if some unforeseen crisis happens. Fear and volatility will return and the bears will appear to be back in the saddle.

But then I expect stocks to make a quiet recovery, led by blue chips, as the bull market moves into its later stages.

So, I’ll sit tight with the vast majority of my holdings. But I’m watching the S&P and especially the Russell 2000, to see if they top their earlier highs as earnings season evolves.

If they don’t, I may take some profits in the small- and mid-cap funds I own to lock in some of my gains. If the market surges again, I’ll leave my chips on the table.

So far, it’s paid big time to be bullish on this market. During the next few weeks and months, we’ll find out if that’s still the best strategy.

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