Now the question on investors’ minds is “why?”  Why did the S&P 500 back off its October high and retrace virtually the entire August-October rally?  Does this mean that the bull market is dead and that a bear market is at hand?  Is the market done for in December?  These are the questions we’ll answer in this week’s commentary.

There are at least three valid reasons for the October-November market pullback.  The first was to put the finishing touches on the fanatical fear of the mainstream investor.  The latest correction certainly accomplished this as headline after headline attests to.  Check out the latest collection of headlines from the Financial Times.  This “fear collage” shows from a contrarian perspective that capitulation is at hand.

The second reason for the pullback was to allow the insiders a final opportunity to load up on stocks in view of the market’s insanely attractive valuation.  Sometimes the “smart money” crowd isn’t always unified in their interests and therefore, at times, some of them can be out of synch with the market’s true underlying trend.  By backing it up one more time in November, the ones who missed the boat at the August low were allowed to jump aboard at roughly the same price levels and even a better valuation level.  According to the insider buying statistics, they are taking full advantage of the opportunity by purchasing stocks at record levels right now.

Another reason for the October-November correction is that it allowed the broad market’s rate of change to synchronize ahead of the next momentum rally.  This rally is almost certainly coming and will be powerful in its forcefulness once it gets going.  The rate of change of which I speak is the momentum of the new highs-new lows on the NYSE.  Until recently, the more important internal momentum indicators were in decline and many of the important indicators were out of synch.  That is about to change in the upcoming weeks as the synchronization improves and the internal momentum reverses from down to up.

We can probably add a fourth reason for the recent pullback.  When the S&P returns to its October high in a few weeks, the bears will probably take this as their cue to begin heavily shorting the market again.  Their assumption will be that if the SPX was unable to overcome the 1575 level in October when it had some momentum and investor sentiment behind it, then how will it be able to make a new high this time with less *external* momentum? 

Most investors don’t take into account the market’s *internal* momentum structure, however, and that’s one of the key distinctions from the October time frame.  Also, monetary conditions have improved since then, as has investor psychology and valuation.  In sum, everything is better this time as compared to the market’s previous peak in October.

By now you can see my answer to the question asked in the headline, “Is the bull market dead?”  That answer is an emphatic “no!”  The bull market is very much still alive, in fact stronger than ever.  The IBES Valuation Model has come close to a record undervalued reading at the bottom of the latest correction.  Bull markets don’t end like this, they *begin* like this!

The latest “fear fad” circling the Internet is the so-called Dow Theory “sell signal.”  The idea behind this misconception is that because the Dow Jones Transportation Average has made a lower low compared to the August correction low, a bear market is imminent. 

This is a faulty understanding of how the Dow Theory works.  The Dow Transportation Average gives its best signals when it confirms the Industrials.  Just because one index makes a lower low while the other doesn’t should not be interpreted as a sell signal at face value.  History will show you numerous instances where the Transports made a lower low at a correction bottom, only for the Dow Industrials to go on to make higher highs.  The October 1998 correction low was one such instance.

This is one problem with embracing a purely technical approach to the market: you can never rely with absolute confidence in any system that looks at the action of price only to the exclusion of everything else.  If all I had to go by was the Dow Theory, I suppose I’d be feeling very bearish right about now, too.  But we know from experience that price alone (or even price and volume) are insufficient to understanding the underlying strength or weakness of the stock market.  It’s a combination of price, internals, psychology and valuation that determine whether the stock market stands on solid ground or sinking sand.

Just how solid is the ground on which the market stands right now?  With bond yields as low as they are compared to earnings yields on the S&P, the valuations couldn’t be better.  In fact, valuations haven’t been this attractive since early 2003 at the bottom of the last bear market.  And this super attractive valuation hasn’t escaped the attention of the insiders, who have been heavily loading up on the stocks of their own companies in the wake of the recent correction.  The fundamental outlook for stocks is outstanding and this is why the so-called Dow Theory “sell signal” carries little weight right now.

The technical outlook is showing vast improvement also.  Look at any number of basic indicators and you’ll see that selling pressure is drying up even as the S&P 500 index made a slightly lower low (on a closing basis) recently.  For instance, the advance-decline indicator, the new highs-new lows and the advance-decline volume indicators have all been making conspicuously higher lows.  This positive divergence of internals compared with price shows a diminution of selling pressure.  Here is one of these important indicators so you can judge for yourself.

Notice the bullish higher high and higher lows pattern in the above NYSE advance-decline volume chart.  That’s a leading signal that the bull market is still alive and that a higher high is expected in the NYSE Composite index.

It has often been said that “no one is going to ring the bell when the bottom is in.”  But from a contrarian standpoint you can see that whenever the key words “gloom” or “gloomy” shows up in the headlines, it's the mainstream media’s way of ringing the proverbial bell (unwittingly) and signaling a bottom is imminent. 

In a recent issue of the Financial Times under the heading of “Banks in crisis,” an entire page was devoted to the credit crisis of 2007 with special attention focused on the world’s leading investment banks.  The headline that prefaced this article was, “Bloodbath expected to claim more victims.” The rather prominent graphic that accompanied it was of a giant guillotine with a sharp and shiny razor’s edge, poised and lifted for the cutting block. Here’s the graphic referred to.

It’s unfortunate that so many millions are driven by the fear and dread they see every day in the news.  But, in a perverse sort of way, it’s fortunate for the stock market that this fear has made its timely appearance since it guarantees the “Wall of Worry” will remain intact.  Every bull market needs this Wall to scale greater heights.

With the bullish signals piling up more and more, we can confidently ignore the gloom and doom being spread by the financial press.  The message that matters most is not contained in the headlines but in the tape.  And that message is saying: “Fear not, happier days are on the way!”

© 2007 Clif Droke
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Clif Droke
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Topsail Beach, N.C. 28445-9831 USA
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