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  • Stocks have rallied nicely higher from June and October lows.
  • Short-term indicators are getting overbought as the S&P 500 intersects its 200-day moving average.
  • Widespread buying triggers an uncommon 10-day advance-decline breadth thrust.

It’s early, but the stock market is rebounding nicely this year. According to the Stock Trader’s Almanac, stocks tend to produce full-year gains when returns are positive during the Santa Claus rally, the first five trading days of the year, and January.

There was debate whether Santa would deliver gains in December's final days and January's first days. Ultimately, he did, as stocks eeked out a modest 0.8% return. A positive return followed through the first five trading days, too, checking a second box on the Almanac’s list.

That’s encouraging. However, it will be a while before we tally January’s results, so investors shouldn’t count their unhatched chickens. We’re fast approaching resistance, and technical indicators are flashing warning signs. In short, we’re at an important point where we may soon discover if bulls or bears will be in charge.

Returns are better than the headlines

Last week, much attention focused on the stock market’s lousy full-year returns in 2022. However, fear-driven headlines mostly ignored that major indexes and sectors have been up since June.

The year's first half was dismal, but the second half was constructive. Many individual stocks increased significantly after making lows during the second quarter of last year. That’s in keeping with a beat I’ve been drumming for months: Stocks bottom before the stock market, and the market bottoms before the economy.

Of course, stocks don’t move in a straight line. And the stock market’s returns since June aren’t an exception. Although many individual stocks didn’t retest their Q2 lows, major indexes undercut lows in October before rebounding. Regardless, as it stands today, an investor who bought in June only to disappear into the wilderness for six months would look at their returns today and feel pretty good.

For example, the following table shows returns for a slate of high-profile index and sector ETFs since June 17th, the day the S&P 500 made its low that month. Would you have guessed those returns based on recent headlines about 2022?

Source: Author using Yahoo!Finance quotes.

Source: Author using Yahoo!Finance quotes.

A hard money market

The great Martin Zweig noted in his book Winning on Wall Street that stocks perform best when the Fed works for investors rather than against them.

Unfortunately, the Fed remains unfriendly. A shift from 0.75% to 0.50% in December was welcome but still restrictive. It’s encouraging that February’s increase may slip further to 0.25%, but that is still a rate increase. Until the Fed signals a dovish policy shift, investors should remain cautious.

The inflation battle is tilting in favor of the Fed, given the December Consumer Price Index CPI declined 0.1% month over month in December. 

Year-over-year, CPI was 6.5%, the smallest increase since October 2021. Core CPI, excluding energy and food (I know how ridiculous excluding common costs sounds, but those costs are volatile, so the Fed discounts them), rose 5.7% in December – the lowest level in over a year. If we exclude shelter, too, CPI was up 4.4%.

Inflation is trending the right way, but earnings remain a wildcard.

The impact of fed funds rate increases takes six months or more, so increases since June are only now impacting economic activity and thus, corporate earnings. As a result, analysts are overwhelmingly revising earnings outlooks lower. They believe we’ll see a -4.1% year-over-year decline in fourth-quarter earnings results and a 0.1 decline in first-quarter earnings. For the full year, S&P 500 earnings have been ratcheted back to about $230 from $241 in September.

The earnings bar has been lowered, but results could still pressure analysts to cut outlooks further. Of course, some pessimism is likely priced into stocks (poor earnings have been widely discussed here and elsewhere for many months), but that doesn’t mean downward revisions won't still take a toll on stocks.

Share prices depend on the multiple investors are willing to pay for future cash flows, so higher rates for longer, as the Fed’s been saying endlessly, caps valuation. If high rates crimp multiples and earnings fall, P/E ratios could spike. That's not necessarily a death knell because stocks have bottomed amid high P/E ratios in the past, including the Internet bust and Great Financial Crisis. Nevertheless, valuation does pose an ongoing risk, particularly to non-dividend-paying, high P/E growth stocks.

The technicals are iffy.

The Dow Jones Industrial Average and S&P 400 Mid Cap average are above important 200-day moving averages, but the S&P 500 is tracked by more assets and it's only now testing it. The technology-heavy Nasdaq 100 is even further back in the hunt, given it’s only testing 50-day moving average resistance.

As the index challenges this resistance, the advance/decline line oscillator Top Stocks’ Helene Meisler uses to gauge overbought and oversold is starting to flash warning signs. 

She wrote yesterday, “My own Oscillator still has another day before it reaches an overbought reading, but one glance at the chart and you can see it is no longer in the middle of the page but kissing the upper reaches.”

Source: Helene Meisler.

Source: Helene Meisler.

Real Money technician Guy Ortmann also sees some signs that stocks could, at a minimum, take a breather. He writes:

“On the data front, the cautionary signals noted Wednesday intensified further. In our opinion, while the charts are bullish, the data appear to be telling us some near-term patience is appropriate as the signals imply some consolidation of the rally that may likely present better buying opportunities. The McClellan Overbought/Oversold Oscillators are all very overbought (All Exchange: +118.37 NYSE: +131.33 Nasdaq: +109.8). They suggest some consolidation as becoming more likely over the near term. The percentage of S&P 500 issues trading above their 50-day moving averages (contrarian indicator) rose to 75.0%, staying neutral but just shy of turning bearish.”

The story is that while things have yet to shift alarmingly toward risk-off, there’s emerging reason to think stocks have gotten a little over their skies.

The Smart Play

One uncommonly rare and bullish indicator is when there’s a 2:1 ratio of advancing stocks to declining stocks on the New York Stock Exchange over ten days. Such a breadth thrust is often discussed by long-time technician Walter Deemer as bullish. It’s also a key cog in Martin Zweig’s “don’t fight the trend” indicator.

In Zweig's 1997 edition of Winning on Wall Street, he noted a 2:1 advance/decline ratio over 10 days happened only 11 times between 1953 and 1991. Over the next six months, the S&P 500 gained an average of 15.2% with a remarkable 100% success rate.

Walter Deemer maintains a more updated table, showing performance from 1949 to 2016. There was one decline at the six-month mark -- a loss of -1% -- in 1992, but the 12-month return for that period was 4.2%. Overall, the average 6-month and 1-year return following a 2:1 advance-decline breadth thrust were 13.7% and 19.8%, respectively, through 2016, according to Deemer.

Why do I mention this? Because Walter Deemer Tweeted today that we were above the 2:1 10-day threshold at mid-day, with a reading of 2.15. We don't have the final numbers when publishing today's Smarts, but the market appears to be finishing strong enough to trigger this indicator (I'll update folks tomorrow).

Source: Walter Deemer

Source: Walter Deemer

Another bullish signal that may trigger this week is Zweig’s 4% rule, which he credits to the famous researcher Ned Davis. 

Using closing prices for Valueline’s Geometric Composite Index, a 4% weekly change can precede solid gains. Zweig wrote that annualized returns for buy signals were 16.2% between 1966 and 1996, exceeding the average 2.7% buy-and-hold annual return. For that weekly signal to trigger on Friday, that index must close above 574.65 (It was 572.51 at 2:50 pm today).

Of course, these (or any) signals don’t mean stocks won’t experience down days or weeks from here, especially since we've already may need to digest some of the recent rally. Nevertheless, if we get a breadth thrust and the 4% rule is triggered, the easiest path of resistance could be buying stocks rather than shorting them.

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