Stock Market Cyclical Bull Approaches Important Test

| March 31, 2011

You may have seen financial media headlines similar to “Stocks Have Best First Quarter Since 1998” yesterday and today, referring to the 5.6% gain logged by the S&P 500 index since the beginning of the year. As usual, the mainstream media are focusing on insignificant metrics and missing the big picture. Stock market behavior during the past several days, weeks and months only has meaning when analyzed in the proper context of the big picture. While it is true that stocks gained 5.6% during the first quarter, they were essentially flat for the year only two weeks ago following the sharp decline from late February.

However, again, these short-term movements are meaningless unless they are analyzed in context, so let’s take a step back and review the big picture. From a long-term perspective, stocks have been in a period of heightened volatility since the crash in 2008, which is typical for this stage of a secular bear market.

The S&P 500 has effectively doubled during the past two years, and that type of extreme, unsustainable rally is nearly always followed by a violent countertrend of comparable character. In other words, the cyclical bull market from 2009 will almost certainly be followed by a swift correction of 20% to 30%, or even more; it is simply a matter of when. At a duration of 24 months, the current cyclical bull is relatively mature given the context of a secular bear market environment, so it could terminate at any time and may be in the process of doing so right now.

The rally off of the September 2010 low has driven stocks to an overextended extreme that is always followed by a violent correction, and the recent break below uptrend support led to the formation of an intermediate-term cycle high (ITCH) in early February. The subsequent two-week reaction off of the mid-March low has now signaled the likely development of the next intermediate-term cycle low (ITCL), bringing the cyclical bull market to an important inflection point.

As outlined last week, stocks are either preparing to extend the rally or forming a double top, and market behavior during and immediately following earnings season in April will likely settle the debate as to which scenario is in control. With respect to short-term cycle analysis, we are approaching the end of the alpha phase rally, and the alpha high (AH) will likely occur sometime during the next several sessions.

If the S&P 500 holds near long-term highs during April and the forthcoming beta low (BL) forms above congestion support in the 1,300 area, a long-term breakout would become more probable, signaling the likely continuation of the cyclical bull market. However, if stocks experience renewed weakness during the next few weeks and begin moving down toward the last short-term cycle low (STCL), the topping scenario would become highly likely. Regardless of which scenario ultimately unfolds, technical and cycle analysis will continue to provide us with the tools necessary to correctly characterize market behavior and develop reliable forecasts.

Category: Commentary, Market Update

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