The S&P500 peaked at 1150 on January 19th, then declined through the end of the month, shedding 77 points, or just under 7%, in eight trading sessions. Global stocks and commodities generally followed suit. Although this sudden and fairly aggressive set-back in the markets has been disconcerting, there have been some welcome developments in the past two weeks that have cushioned the blow: (1) it was satisfying to see Bernanke assailed (and his confirmation momentarily in doubt) for his role in the credit and real estate bubbles; (2) the ascendancy of the previously marginalized Paul Volcker within the Obama administration raises hopes of substantive reform of our bloated, parasitic financial sector; and (3) the Massachusetts election increases the likelihood of political compromise and moderation in policy-making.

Market's Technical Health Downgraded from Bullish to Neutral

The technical picture in the stock market has changed quite a lot since the January 19th high. After breaking to the upside of the November/December consolidation zone between 1080 and 1120, the S&P 500 is now retesting the lower boundary of this support area, as shown in Exhibit 1. A decisive break of this boundary (i.e. a close below last Friday's low of 1071) would project a test of the late October/early November low of 1030, which would also represent the first 10% correction since the bull market started last March. Thus far, corrections have been limited to 5% to 8%. The recent decline has also seen significant deterioration in the market's "internals". The number of net new 52-week highs on the NYSE (i.e. the number of stocks hitting new 52-week highs less the number of stocks hitting new 52-week lows) plummeted from over 400 in early January to fewer than 50 at last Friday's close, putting this indicator in a precarious position. The strength of the bounce from short -term oversold conditions (which may have started yesterday) will be revealing, and provide additional clues as to whether the long-awaited 10% correction is in process. The S&P500 needs to rally back above 1120 to repair the technical damage that has been done.

The Bullish Case has Weakened, but Still Deserves the Benefit of the Doubt

At the start of the year, the impressive technical condition of the market (i.e. a very strong "tape"), combined with the extremely loose monetary policy of the Federal Reserve, were the strongest arguments for further bull market gains. Earlier in the rally, stocks benefited from being attractively priced and under-owned, but that is no longer the case. At 18x long-term trend-line earnings, the S&P 500 is now somewhat overpriced, and investors came into 2010 with their most aggressive allocation to stocks since the last bull market ended in October 2007. The bullish case has weakened somewhat as a result of the recent technical deterioration, but still warrants the benefit of the doubt. It would be very unusual for the ultimate peak in the bull market to have occurred in the manner observed in January. Early in the month, all of the major averages moved to new bull market highs; the NYSE Advance/Decline Line, a measure of market breadth, confirmed the new highs in the indexes; and selling pressure was at a low point for the bull market. Those are not the conditions that historically have been associated with major market tops. Typically, breadth breaks down three to six months in advance of a peak in the broad indexes. According to Lowry Research, there have been only three instances (out of 18 bull markets) dating back to the 1940s where the NYSE Advance/Decline Line did not begin to weaken months before the formation of a major market top. Moreover, barring some catalyzing event, market participants do not collectively decide to do major portfolio liquidations all at once. Rather, then tend to move at different times and incrementally, which is why bull markets tend to expire over a period of time, with several retests of the highs and the gradual appearance of divergences.

Other, non-technical factors also argue for the idea that the market is just experiencing a normal correction. The interest rate environment remains benign. Treasury yields are low and stable, and credit spreads only ticked up modestly in the recent equity market sell-off. The stimulus-driven economic recovery shows no signs of lapsing back into recession in 2010. Indeed, fears of stimulus being significantly curtailed seem misplaced. Bernanke was in fact confirmed for a second term, and the wording of last week's FOMC Monetary Policy Statement was unchanged: "The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period." As for fiscal policy, the bottom line is that the Obama Administration intends to keep spending. In last week's State of the Union speech, Obama stated:

"I am announcing a second fiscal stimulus to get the US economy roaring again. Fiscal policy should be counter-cyclical. If we do not spend more now, then the economy will nosedive and deficits would be even larger."

Yesterday, Obama proposed a budget that forecasts a $1.6 trillion deficit for fiscal 2010, which is higher than fiscal 2009's record shattering $1.4 trillion deficit. Obama's proposed budget deficit for fiscal 2011 is $1.3 trillion. How anyone can be bullish on Treasury bonds in the face of these deficits is mystifying.

As far as stock market tactics are concerned, new buying should be deferred until either a bottom is confirmed (evidenced by a move back above 1120), or the stock market registers the long awaited 10% correction.

Risk-averse investors, or investors with a more bearish predisposition, could consider the following tactics: (1)hedge or lighten up following a possible short-term rebound to the 1100 area, or (2) on a break on a closing basis of 1060, which is ten points below last Friday's low. Investors more comfortable with risk and volatility can operate for now with the assumption that a 10% or so correction is probably the worst-case outcome in the near term, and that the bull market will live to celebrate its one year anniversary in early March.

An Argument for Playing it Safe

But shouldn't investors aggressively buy the first 10% correction that comes along in a bull market that is not even a year old? The historical playbook would say yes, but discretion (and a focus on capital preservation) seems the better part of valor in this instance, given the mind-boggling uncertainties investors face. Jeremy Grantham of GMO put it well in his recent quarterly letter:

"It is easy to be confused, for this is a remarkably complex time. We have never in our lifetime seen a financial and economic bust such as the one we just had. We have never experienced such rapid deterioration in the government's budget and in the balance sheet of the Fed. What hope do we really have in making accurate predictions of how the world will recover from all of this, and in what ways it will be changed? Very little."

Gold Continues its Bullish Consolidation

The gold market has been behaving as expected. Following its $300 advance from August through November, we thought that gold would pull back and consolidate for a few months before commencing its next move to the upside. Gold has been acting well in light of the strong rebound in the U.S. dollar since it bottomed simultaneously with gold's peak in late November/early December. The U.S. dollar index has rallied back to levels seen last August, but gold has only given back about a third of its gains since August. We continue to be bullish on gold on an intermediate to longer term horizon. Driven by demand from both private investors and emerging market central banks seeking diversification from paper currencies, we expect gold to reach $1500 at a minimum over the next two to three years, and it could potentially trade much higher if speculative dynamics really take hold. The downside risk in gold should be limited to $1000 to $1050.

JD Steinhilber
President - AgileInvesting
www.agileinvesting.com