It’s called a “snap-back rally”, something that occurs when the markets are extremely oversold and have experienced a straight down plunge that gives no quarter to investors trapped in the market. Sometimes these rallies can be quite powerful and are usually sharp and fast. They are temporary and are usually followed by a re-test of the lows and sometimes break lower.

However, a truly “tradable” bottom is an altogether different animal.

“”What do I look for?” asked a reader last week.

  One area to watch is the options market. This is the arena where speculators place bets on whether a security or market will drop further (or move higher). In this case, I’m looking at the put options on the S&P 500 Index. On Thursday put buyers were practically in a panic to buy put options on the S&P. Over one million contracts changed hands, which represents 2 ½ times the average daily volume for these contracts.

The last four times this has occurred (February, June, August and November, 2011) the markets were close to an important bottom. But this is only one variable. Some other signs include the following:

The talking heads on television will stop promising a “near-term” bottom. Instead, they will throw in the towel and start advising viewers to sell everything because there will never be a bottom.

Those pundits who are continuously cheerleaders for the markets called Perma-bulls will begin to back step, vacillate and some might even go bearish while the loudest and most obnoxious Perma-bears will announce that they are “shorter than ever before and you should do the same.”

Start listening to the radio on the drive to work. It is a good sign when broadcasters start leading off with the latest bad news of the market.

Rumors of hedge funds in trouble, big margin calls and the like are another sign we are closing in on a bottom

My clients will call in a panic demanding I sell a stock or mutual fund that up until now I could not convince them to part with at any cost (think “A”). The conversation usually begins with “Oh my God” or “Did you see that?” and ends with “sell everything.”

Finally, most bottoms are accompanied by a “flush” where selling volume explodes and prices drop as if they are on an express elevator.

All of the above, plus a couple more factors come into play when I am looking for a tradable bottom. Yet, I must admit that it really comes down to a feeling that one develops after many years of watching markets and experiencing nasty down turns and glorious rallies. It is why managing money and investing in markets will always be an “art” and never a science.

I couldn’t close without mentioning a worldwide social networking phenomenon that went public on Friday. The build-up to this initial public offering reminded me of the “John Carter” movie trailers that I was forced to watch every time I turned on the television, and its debut appears to be as much of a disappointment as the man on Mars. When I look back through history at other hyped up IPOs that were touted as the greatest thing since Moses parted the Red Sea, I discovered that most of the future upside in these stocks was priced in by the close of the first trading day. On average, the price of these stocks was down from the offering price six months later. 

In April, the labor force participation rate, the employment-to-population ratio, and the number of people who said they are employed all fell in the month. The sad fact was that 350,000 people quit looking for jobs altogether. As a result, the labor force technically shrunk, which makes the overall unemployment rate look better than it actually was.

Investors ignored the fact that the number of jobs that were reported by the Bureau of Labor Statistics over the last three months was all revised upward. In total, during the last quarter 53,000 more jobs were gained but went unreported until now. But the market focused solely on this month’s data and sold accordingly.

I think that responding to an individual data point is a mistake. Data like unemployment numbers, GDP and the like should be viewed over time. It is the trend that counts, not individual data reports, because government statistics by their nature are highly inaccurate and most of the time undergoes several revisions before a final figure is reported. Yet, the markets insist on trading off today’s numbers as if they held the answer to the market’s directions for days or weeks into the future.

The big drop in labor participation, however, is not a good sign for the economy or for the administration. In an election year, the GOP front runner, Mitt Romney, is asking voters if they are better off today than they were at the beginning of the Obama Administration. Clearly those 350,000 workers who have abandoned the work force will answer with a resounding no.

And yet the total number of jobs has grown since President Obama came into office, so both sides will use the unemployment data to suit their own agendas. As the politicians blame each other for the failures and take credit for the successes, no one is really enunciating a clear and precise plan for how to increase the number of jobs in this country. It is simply a game of sound

Overseas, this weekend there are also elections in both France and Greece. It appears from the polls that Nicolai Sarkozy will lose the presidential election and French Socialist candidate Francois Hollande will take over the reins of power. This will present a problem to both Germany and the European Union since Hollande intends to renegotiate the recent austerity pact signed after much deliberation and market turmoil by EU members.

In Greece, parliamentary elections will be held in the midst of a deep recession caused by these same austerity measures. There is enormous unhappiness among Greek voters toward the European Union and its own leaders in both major political parties. Extreme and radical fringe party candidates have been gaining support.   There is a chance that voters will not only reject both parties but elect new radical leaders that will want to either renegotiate all their past agreements with the EU or outright reject remaining agreements within the Eurozone altogether.

Given this background, it is not surprising that investors are selling first and waiting for the elections results later. Next week could offer investors a wild ride if things go the wrong way in Europe. Despite the sell-off this week in the markets, we are still a mere 33 points below the level of the S& P 500 Index at the beginning of April. We could easily fall further given the right circumstances. My advice is to stay defensive and remain on the sidelines until the landscape is a bit less muddy.

Markets Blast Off

“I don’t get it,” said a reader on Friday morning. He was sure that the markets would crater on the back of a disappointing Gross Domestic Product number for America’s first quarter. The data indicated our economy slowed from last quarter’s 3% growth rate to 2.2%.

“Not only was the U.S. market up, but so was the Spanish market. That doesn’t make any sense. Will you help me out here?” he asked

It is true that S&P, the credit agency, downgraded Spanish sovereign debt Thursday night by two notches from “A” to “BBB+”. S&P believes that Spain’s budget deficit is going to worsen based on further declines in their economy. In a different era our reader would have been correct in anticipating a downdraft in Spain’s stock market, but not in this environment.

  Investors took the initial decline in their stock market as another buying opportunity. By the time the U.S. opened on Friday the Spanish market was up by almost one percent. So what makes weak economic data, whether in the U.S. or Spain such an opportunity for investors?

Investors are conditioned to believe (after two and a half quantitative easings here at home and the on-going monetary stimulus in Europe) that the weaker the data becomes the higher the probability that the governments will step in and save us. Thus, the worse the news becomes, the better it is for the future of the stock market. There is plenty of precedent to believe that.

Just look back at what has happened every time our government-influenced stop and start economy began to slow over the past few years. The cycle began with the first stimulus package combined with central bank monetary stimulus (QE I). For a short time the stock markets skyrocketed, the economy grew and unemployment began to decline. But as QE 1 waned so did the economy, and with it the stock market.

 The Fed waited and hoped the slowdown was simply a blip but in the end the negative data forced the Fed to launch another program (QE II). Once again the economy and the markets reacted by moving higher. But here we are again. The economy is slowing and investors are expecting the Fed to bring a new punch bowl to the party.

Will the Fed cooperate? Yes, at some point if necessary.  QE III is not on the table quite yet and may never be if the economy can find legs of its own. But if the economy and unemployment begin to slow further then we can expect another save by the Fed. Of course, the devil is in the details. The key words to focus on are “if” and “further.” Those words appear to represent one thing to the Fed and another to investors.

At this point, no one (including the Fed) really knows if the country is in a sustainable recovery.  Investors who expect the Fed to launch QE III because the economy declined .80 basis points in one quarter are smoking something.  In each of the prior cases of Fed easing the stock markets and the economy had to stall dramatically before the next round was launched.

You might recall that in each case we had to suffer an 18-23% stock market decline before the Fed stepped in to save us. If those same investors expect the Fed to ease with the stock markets approaching the year’s highs then once again, give me some of what you’re smoking.

Yet, in my opinion, that’s what the markets are betting on.  If we look back at the month to date, we could argue that the markets gave us the 5% correction we had been looking for and are now poised to move higher. A contrarian indicator like bearish market sentiment is rising. Dips are being purchased once again and momentum seems to be on the side of the bulls for now.

I’m thinking we could run another couple of percent here on the S&P 500 Index, at least to 1,420 or maybe as high as 1,450 over the next few days or weeks. If you are nimble, you might be able to take advantage of that move. If, on the other hand, in-and-out trading is not your style than just stay where you are and enjoy the fireworks.

All week long a barrage of weaker than expected data buffeted the stock market. Weaker manufacturing and home sales, consumer confidence and rising layoffs paint a portrait of weaker economic growth and higher unemployment ahead.  As I have written in the past, a stock market that is priced for perfection can’t take much more of this negative news.

On the other hand, 80% of the companies that have reported so far this quarter have beat estimates. One should take the number of “beats” cynically. It is common knowledge that Wall Street analysts reduce their earnings forecasts ahead of time so that the hurdle for beating estimates for the companies they follow is absurdly low. The entire game of earnings forecasts has become somewhat of a joke within the investment community.

Europe continues to cast a long shadow over U.S. investment. Spain’s bond auction this week had everyone on edge. It came in poorly but it wasn’t a complete disaster.  Markets in the beginning of the week sold off in advance of the auction.  Investors expected the market to rally but instead we had one of those extremely volatile up and down days that made everyone’s stomachs churn.

This weekend investors’ eyes will be glued to French election results. The French electorate will choose among 10 candidates with a May 6 runoff scheduled between the top two winners.  Socialist challenger Francois Hollande is expected to win this weekend’s vote. He has promised to revisit the European Union’s fiscal austerity agreements if elected. Investors fear this will upset the entire European financial pact, of which France is an integral player. That leaves more tension and more stress for market participants.

The market internals continue to deteriorate. I have noticed that while the volume on upside days is anemic at best, the volume expands substantially the days the market sells off. Take Thursday, for example. It was a down day and volume was 20% higher than normal. It indicates that investors are cashing in on the gains of the first quarter every time the stock market gets close to its upper limits.

We seem to be trading in a narrow range around S&P 500 Index’s 50- day moving average. At the moment that level is 1,380. Remember, a moving average is just that and it changes from day to day. Clearly we have not made any progress at all since the end of the first quarter. In fact, we have lost 2% since then.

One can argue that the markets are simply catching their breath after their three month sprint. I don’t disagree with that prognosis. As I have mentioned before, there are several ways a market can digest gains. The first is through a pullback commonly known as a correction (if it exceeds 10%). The second involves a lot of backing and filling that sometimes can stretch out for several weeks or months. Either way the market consolidates its gains and is then ready for further upside.

There are also times in which a market will do both. Decline, churn, drop again, churn and so on until it reaches a level where investors believe it offers value based on economic and other factors.  I suspect we are in that kind of market for a little while. We are also fast approaching May. We have all heard the expression “Sell in May and go away.” Historically speaking, that has been very good advice. I await the end of the month with bated breath.

Risk has returned

Monday and Tuesday were downright ugly. The next two days we climbed back up and then on Friday gave some back. It was a roller coaster and is reminiscent of the period from May through October of last year. Imagine that.

It was a down week, despite a surprise upside earnings surprise from Alcoa, which is usually the first company to report each quarter. Further good news from some big banks failed to inspire the market, however. Once again, as I wrote last week the rain in Spain has flooded our plain.

Spanish banks borrowed twice as much from the European Central Bank in March as they did in February amounting to $419 billion. The ever-present angst among European investors has focused on Spain this month. Next month (or week) it could be Italy, Portugal or that popular whipping boy, Greece, that’s back in the news. 

Underlying the recent climb in Spanish sovereign bond yields is a brewing housing crisis and a faltering economy. Spanish banks are also bleeding. They are grabbling with 300 billion euros in property loans and the Spanish government has said it isn’t prepared to inject any more capital into the sector. It’s the same old song that will most likely end in another bailout for Spain.

I shouldn’t blame Spain for all our worries. China’s slowdown has also contributed to investors’ worry. The annual rate for Chinese GDP growth slowed in the first quarter to 8.1% from 8.9%. I wish our growth could be even half that rate but everything is relative. And relative, in the context of Chinese economics, equates to slower growth, slower demand for materials and commodities, and a host of other goodies that the world depends on to drive their own economies. A hard landing in China coupled with a recession in Europe would not be an auspicious development for world economic growth. Right now the state of China’s economy is muddy at best.

As for our markets, the decline I have expected has begun. Pullbacks vary. If we take a look at the last nine times the markets have declined going back to mid-2010, we see that the longest correction was 22 days. The average was 15 days. Snap-back rallies can last from two days to seven days. This week’s snap-back lasted two days.

What is clear is that volatility increases substantially during times like these. My advice: do not try to trade the ups and downs. You will be left with a big hole in your portfolio and end up losing far more than the market corrects. If you had decided prior to this pullback that you were going to stick with the markets, then do so, take your lumps and look to the long term.

If you followed my advice and raised cash, it is time to be patient, watch the markets gyrate but don’t let that cash burn a hole in your pocket. Patience in this kind of environment is worth its weight in gold.

Bill Schmick is registered as an investment advisor representative with Berkshire Money Management.  Bill’s forecasts and opinions are purely his own. None of the information presented here should be construed as an endorsement of BMM or a solicitation to become a client of BMM.  Direct inquires to Bill at 1-888-232-6072 (toll free) or e-mail him at Bill@afewdollarsmore.com

I guess when it rains, it pours, at least when it comes to bad news in the stock markets. European Central Bank President Mario Draghi added to investor worries by expressing his concerns of future inflation and was therefore less than anxious to provide any more financial stimulus to the European crisis.

The justification for the recent European stock market rally has been investors’ belief that central bankers stand ready to flood the markets with more and more money at the slightest whiff of additional problems. Draghi’s remarks, coupled with the Spanish bond auction, did not play well among investors.

On this side of the pond, the Fed’s meeting notes released on Tuesday afternoon indicated that unless unemployment and the economy take a sudden turn for the worse, investors should not count on further easing by our central bankers.

Oh me, oh my, lions and tigers and bears!

As I have reminded readers several times in the last month or two, this rally has been fueled by the conviction that the Fed will “soon” announce QE III. Tons of newsprint has been devoted to exactly when this will occur. The latest date pontificated by the most influential brokers is “no later than June.” It is therefore mystifying that only two of the 12 FOMC board members support further easing at this time.

Those who have been following my advice have already raised cash, sold their most aggressive stock holdings and are therefore perfectly positioned to take advantage of this pull back.

“So how low can we go?”

It was the first question I received this week from readers.

The short answer is 5-8%. That would push the S&P 500 Index down to the 1,310-1,350 level. In the scheme of things that is not much of a drop given the 11% rise since the beginning of the year and 20% rise since October, although any loss is painful for investors. At that point, I think the market would more accurately reflect the present state of the economy and its prospects.

There is some discussion among economists, however, that the spate of good economic data we have been experiencing lately has been “front-end loaded.” As a result of an abnormally warm winter and spring in two-thirds of the country, economic activity has been bunched into the early part of the year and we may see a slowdown as we enter the summer months.

I have maintained that the markets have been priced to perfection and that any bad news would have an inordinate impact. We will have to watch the economic data closely over the coming months for any clues to address those front end concerns. In the meantime, be prepared for some choppy action and potentially more downside this month in the markets.

Is the market a time bomb ?

In the short term the answer is a definite maybe. If you put a gun to my head however, I would bet that sometime in the second quarter we will have a correction. In April, if history is any guide, we usually see the peak in stock market performance. As the month progresses, investors begin to “sell in May and go away.”

Monday the market received its latest shot of adrenaline when Federal Reserve Chairman Ben Bernanke assured investors that the easy money we have become addicted to is still needed. That sent the S&P 500 to its best closing level in almost four years. Those gains were led by the same group of stocks that have defied gravity and have continued to make higher highs without thought to earnings, price or any other metric of valuation.

One particular darling of the market that begins with “A” (hint: one of these a day is supposed to keep the doctor away) has witnessed its market value increase by $172 billion in the last two months. That is equal to the entire value of a large, well-established healthcare and consumer products company with over a 100 year history. It now represents 4.4% of the S&P 500 Index and by itself is larger than the entire U.S. utilities industry.

“A” will have to sell $2.6 trillion of products and services over the next decade (amounting to 1.5% of U.S. GDP) to justify that valuation. That would mean that every person in this country would need to spend $750/year on its products for the next ten years. I remember a similar period in stock market history where valuations got this high and we all know what happened to the DOT.com party. Another indicator, the number of net new 52-week highs of stocks on the S&P 500 is shrinking from 280 in the beginning of February to 63 today. That should elicit some concern since the same index moved up from 1,345 to 1,408 during that time period.  Warning signs like this abound, but remember that markets can remain irrational far longer than you or I can remain solvent.

My sentiment indicators are still flashing amber as bullishness remains at historically elevated levels. If one looks at psychology, as it applies to market cycles, it appears we are on the other side of euphoria which is the top of the bell curve of investor emotion.  To the right of this euphoric top, the markets back and fill. We are in the complacency stage right now where most investors and market pundits believe that all we need do is cool off a bit before the next rally. What’s after that?

If the markets begin to decline anxiety sets in followed by denial, panic, capitulation and then anger. This week we had three down days in a row, which is about the most we have endured all year. Many traders were expecting the quarter to go out with a big bang as institutional buyers did some end of quarter “window dressing”. The opposite occurred and instead we saw some profit taking in the high flyers.   Historically, bull markets have averaged 39 months in length. If you date this one as beginning in March 2009, then this bull is over three years old. That means by the end of the second quarter, you should be wary of a market top. In addition, during the last 21 election years between March 1 and Election Day, the maximum correction has been a loss of 9%.

None of this is new information because everyone is looking at the same data. The question is when you decide to pare back. The greater fool theory applies less and less these days. Those who hang around to the last moment often find themselves with no one willing to buy their high priced securities. Don’t let that happen to you.

Over the last seven years Chinese government central planners have established a stated economic growth rate for China’s economy of 8%. This week, Chinese Premier Wen Jiabao set a growth target for his nation’s economy at 7.5% for 2012, which is half a percent lower than targeted.

At the same time, government forecasters in Australia indicated that iron ore exports may decline by as much as 8.5% this year. China was once again the culprit since it is a large consumer of Aussie iron ore. Iron ore is one of the main inputs in the production of steel. At the same time, Australian BHP Billiton, the world’s biggest mining company, predicted that China’s steel production is slowing as the country switches its focus from exports and massive building projects to the Chinese consumer and domestic consumption

Shaving one half of one percent off an economic forecast may not seem like a lot, but when the world’s stock markets are priced to perfection, any ill wind that may blow quickly accelerates to gale force among market participants.. The Chinese stock market nose-dived on the news. That market, which had experienced fabulous gains from 2003 through 2008, has languished and has largely been excluded from the rally in stocks that we have experienced since 2009.

To its credit, the U.S. stock market weathered the news quite well. It simply stalled the equity rally for this week. Although somewhat muted, sentiment is still at or close to highs that have traditionally signaled market corrections. In addition, The Chicago Board of Trade’s Market Volatility Index, called the VIX, has hit lows that have not been seen in years. Volatility has been the watch word of the markets over the last two years. The price of the VIX today would indicate that investors are expecting smooth sailing into the future with no clouds upon the horizon.

The S&P 500 and NASDAQ Indexes are having their best quarters since the second and third quarters of 2009. Europe’s problems also appear to be behind us although lingering concerns over the financial shape of Portugal contributed to this week’s nervousness. European exchanges had their worst week of the year with a decline of 4% overall. We will see if the U.S. market can decouple from the kind of profit-taking that is occurring across the Atlantic.

The recurring theme among everyone I talk to is when a pullback will occur.  It was the topic of an entire evening’s dinner conversation on a recent trip to Manhattan. Various members of the financial community gave their forecast. . None present expected the markets to continue higher. That, my dear reader, is an important contrary indicator. I suspect that there are still a lot of investors, both retail and institutional, who are underinvested in equities and are just looking for a chance to put more money into the market.

Since there will always be those who will jump the gun, any minor decline continues to be met with a wave of buying from those still sitting on the sidelines. I expect that absence any more bad news, the markets will continue to experience shallow pullbacks followed by a slow grind higher. I feel fairly confident that somewhere out there a sell off  is coming but exactly when is simply too hard to predict.

How long before the Fed turns off the spigot?

If you follow technical analysis, you should be aware that the ten, twenty and thirty year Treasury bonds have all broken support levels that have been in place for almost a year. Interest rates on the ten-year treasury appears likely to test 2.4%-2.5%

At the same time, gold also broke multi-month support. The precious metal is now trading below its last support level at $1,675/ounce. It appears headed for $1,600/ounce or possibly lower. Is this the beginning of a trend in dumping safe assets and embracing risk as represented by the stock market?

The answer is no. I believe that the siren call of the stock market’s easy gains this year have convinced some investors to abandon their safe haven assets and take a plunge in stocks after months on the sidelines. That, in and of itself, may be a warning sign since that trend usually happens close to a top in the markets.

However, in the case of the bond market, the recent decline could be a warning shot across the bow that interest rates are about as low as they are going to get. The risk in the “super safe” U.S. Treasury market is high, in my opinion, and I believe it is simply a matter of time before Treasury bonds hit a wall.

 In a recent interview, Bill Gross, the so-called bond market king at PIMCO, agrees with that opinion, but Gross said the same thing last year and has been wrong thus far. He isn’t saying that this week’s decline is the start of a major decline but he does warn that a decline in bond prices is coming soon.

Some observers have a different take on the decline in both bonds and gold. They believe that the market’s absolute conviction that the Federal Reserve is about to launch a third tranche of quantitative easing is ill-advised. They argue the gathering of strength in the U.S. economy and the welcome decline in the unemployment numbers has put the Fed on hold as far as any new stimulus is concerned.

If that is the case and QE III is simply a pipedream, then it spells the end of Fed stimulus by June of this year. Investors’ first reaction to this event would be to sell Treasuries and also gold. Why?

 Less stimulus would mean less inflation and therefore less reason to hold gold, a classic inflation hedge. The Fed-engineered cap on interest rates would also disappear, leaving the markets to determine where interest rates should be. And, by the way, if the stock market truly believed that QE III was off the table, I don’t think it would play well with the stock market averages.

Consider that global markets have had a negative reaction each time the world’s central banks signaled a cessation of monetary stimulus. Within weeks, if not days, stocks declined and did so dramatically.

Clearly, stocks are still the flavor of the month, so investors are obviously still convinced that further monetary easing is just around the corner. Just yesterday, I read a strategy piece from one of the most influential brokers on Wall Street who predicted QE III would be announced by the end of the second quarter.

Make no mistake there is still momentum in the market. Despite my caution, I believe the S&P 500 Index is headed for 1,425 or even 1,450. As we move higher, I will take profits.

“Let’s say it was the beginning of one,” I answered.

“So how much longer am I supposed to wait? I’ve got tons of cash and it’s not earning me anything.”

Sometimes the hardest thing in the world is to do nothing. This ap[pears to be one of those times. Yes, we did pull back over 1% earlier in the week in all three averages but the downside was short-lived and the markets regained all they had lost by the end of the week. We can thank world governments for that performance.

The EU and its central bank successfully concluded the renegotiation of Greek debt. Just over 80% of Greek bond holders “volunteered” to exchange their old bonds for new ones that are worth less than half the value. For all intents and purposes this amounts to a massive bond default by the Greek government, but that’s not how it is playing out.

When governments are involved, what normally would have become a default becomes something else. In this case it becomes a “restructuring” and not an embarrassing default. The markets rallied, bidding up European stock markets at the news. They ignored comments from the head of the European Central bank who said that further interest rate cuts and other stimulus measures are at an end. At the same time, the fact that Europe is also entering a recession seemed to be unimportant.  

  In the U.S., the Federal Reserve added to the cheer by planting a story in the Wall Street Journal. The gist of the article was that the Fed is considering a new kind of bond purchase that would boost the economy further but would be designed to reduce the inflationary impact of such purchases. The economic term for this is “sterilization” and just the mention of additional easing had investors buying back stocks. As I explained last week, the entire move up in the markets since October has been based on central banks flooding world markets with more and more money. This is like offering investors a huge punchbowl with all you can drink right now. Nothing else matters right now and like those who indulge too often and too much there will be a price to be paid down the road.

As I pointed out to a client this week, the markets did recover on all this good news but are still at about the same level they were when I suggested lightening up on your most aggressive equity holdings. Actually, the Dow Jones Industrial Average was around 13,000 at the time and it is now trading lower than that.

The S&P 500 Index and NASDAQ are where they were on March 1. Gold and silver have been losing trades for the last few weeks as well. But don’t get me wrong; I’m not bearish, just cautious in the short-term. I expect a choppy market at best and in that kind of environment it pays to wait it out.

Many investors believe the sidelines are an unacceptable position in today’s markets. Granted, sitting in cash at money market rates yielding next to nothing is akin to watching grass grow in the middle of winter. The point I would make is that sitting in cash is not about making money. It is about not losing money and that can be a smart move sometimes.

I have no crystal ball that tells me this period of caution will only last a week or two or drag on for a longer period of time. I’m guessing it will be shorter than longer so I’m willing to keep the cash and forego investing it in bonds or something else that provides a greater yield. Part of that decision is based on tax considerations and trading costs. However, those may not be important considerations to you. I can only council patience; the rest is up to you.