After faltering for the past week, stocks rallied Thursday morning on news that third quarter GDP was slightly stronger than expected. The 3.5% growth rate ended four quarters of economic contraction.

U.S. Commerce Secretary Gary Locke issued the following statement in response to the news.

“Today’s numbers indicate that the tough decisions this administration made to rescue the economy from the abyss were correct. We’re headed in the right direction, and even though there are still too many Americans out of work and still much work to be done, without the action taken in the early days of this administration, the pain families are feeling today would be much worse.”

There is little doubt that investors and traders will be encouraged by this news and that stocks will continue to rally. Unfortunately, a positive GDP number does not mean that the economy has returned to full health. In fact, there are numerous signs that point to continued economic weakness.

The current situation reminds me of 1999, when many experts were warning about the inflated valuations of technology stocks. In spite of those warnings, people continued to buy technology stocks and drove the prices even higher. Eventually the tech bubble burst, because that’s what happens in any situation where something gets so overextended.

Today the P/E ratio for the S&P 500 remains near an all-time high, yet investors continue to bid up the price and the valuation. This is in spite of the fact that almost 1 in 5 people are out of work and federal deficits are rising at an unprecedented rate.

Below is a chart of the New York Stock Exchange composite. The gold line is a 50-day moving average (MA) of the price. In recent days the MA was breached, but today’s positive market action is likely to push it back above that mark.

The middle portion of the chart is a relative strength index. This indicator broke below the 50 level but today’s action should also push it back above that mark. That is usually an indication that an investment has enough momentum to sustain an advance.

The bottom portion of the chart is a moving average convergence divergence (MACD). This indicator is also turning upward again in response to market action.

Because the rally is expected to continue, we will cautiously be entering some market positions. As indicated above, market values for many stocks are currently inflated meaning risk of a significant correction remains high. So we will be very selective in the investments we choose and we will trust our indicators to warn us when it is time to get back out.

It is impossible to predict when the next major downturn will occur. It might be a month from now or it might be several months. In the meantime, we will try to use this opportunity to take advantage of Wall Street’s optimism.

F.S

While U.S. equity markets have generally been going up over the past six months, some unexpected leaders have emerged in the past few weeks. If you have paid any attention to the financial media in recent weeks, you have no doubt heard comments about significant weakness in the U.S. dollar.

The U.S. markets have done well, but many foreign markets are doing much better. The chart below shows how the dollar compares over the past six months to a couple of other currencies. Although I have used the euro and yen for this example, almost all other currencies are outperforming the dollar in recent months.

You have also undoubtedly heard that gold is at record high levels. That is also primarily a function of a weaker dollar. While gold has traditionally been used as a hedge against inflation, many traders and investors are now using it as a hedge against a weaker dollar.

Perhaps the most important question one might ask is why the dollar is weakening against other currencies. The main reason is because of the huge debt the U.S. government has amassed in an attempt to jump start the economy. Each dollar the government prints drives down the value of all the other dollars in circulation.

One can debate whether a weak dollar is good or bad for the U.S. economy. That really is not a critical concern for investors at this time. What investors need to know is that as long as the dollar remains weak, other alternatives are likely to outperform the U.S. stock market. Right now those alternatives include some commodities and some international funds.

The chart below shows how the S&P 500 has fared over the past six months compared to some other investments. For the period, the Latin America ETF (ILF) has shown great strength. Oil has been very good over the past month, but has faltered slightly the past couple of days. Although gold is at record highs, over the past six months it is still trailing the S&P 500.

Many of the investments that benefit from a weaker dollar carry high volatility and might not be suitable in large doses for investors with a conservative or even moderate risk tolerance. So investors taking positions in these types of investments need to be cautious in their approach.

F.S.

It has been two years since the most recent peak for major stock market indices. In October 2007, the Dow, S&P 500, and the Nasdaq all reached new multi-year highs.

Since then, we experienced a recession and a market collapse that many economists have called the worst since the Great Depression. Below is a chart that shows how the three major indices have performed over the past two years.

It is easy to see that although stocks have rallied strongly since March 2009, the major indices remain well below the highs reached in October 2007. As a result, many investors are still suffering the effects of the losses sustained in the downturn.

One other interesting observation that is easy to see on this chart is the steep decline that occurred in October 2008. A year ago major indices began the month with one of the sharpest drops in market history. In spite of the dramatic recovery seen in recent months, the indexes are now at about the same level as a year ago.

At this point it is difficult to predict where the market will be a year from now. While it is nice to think that the recession might be coming to an end, many economic challenges remain.

Stocks have advanced strongly for almost eight months now. In market history, it is rare to see such a sustained advance even during a powerful bull market without a substantial retracement or a period of sideways consolidation. It is impossible to predict whether such a corrective period will soon occur, but as we have explained in previous weeks, there are many reasons for investors to exercise caution right now.

F.S.

For at least the short term, stocks have again dodged an expected and overdue correction.  Last week I wrote that the S&P 500 was falling toward its 50-day moving average and that a break below that mark could trigger a more serious correction. Instead, the index bounced off its 50-day MA and began moving higher. That type of market behavior is typically associated with strong bull market trends.

Anyone looking at a price chart of major market indices over the past six months would conclude that stocks are in a very powerful uptrend. On the other hand, if one were forced to make an assessment of the markets based solely on fundamental data the determination would undoubtedly be much different. In spite of the surge in stocks, the economy continues to face drastic challenges that will take years to resolve.

Many traders and investors seem to be ignoring long-term economic realities in an attempt to capture short-term gains. But that is a high-risk game that could end disastrously for those who are participating.

Stock market advances are ultimately based on corporate profits. Investors are rewarded when corporations are making money. When a corporation has no profits there is no financial reason to own its stock unless an investor believes it will have future profits. Investment based on hope rather than on economic fundamentals is called “speculation.” Speculation can drive an investment higher for a time (creating an economic bubble), but without sufficient profits the investment will eventually collapse.

In the United States, corporate profits are primarily driven by consumer spending, which normally accounts for about two-thirds of the nation’s economic activity. For the first three quarters of this year, corporate earnings have been dismal in part because consumers are paying off debt and saving money rather than spending. The Federal Reserve reported this week that total outstanding consumer debt fell by $12 billion in August, a 5.8 percent annual rate of decline. The July rate was revised to show a decline of $19 billion, or 9.1 percent. Does anyone else find it ironic that the response of individuals to this economic situation is exactly the opposite of the increased spending and debt espoused by the government?

In addition, a rising unemployment rate and cutbacks in worker hours means that consumers have less money to spend. According to the most recent employment summary from the U.S. Bureau of Labor Statistics, since the start of the recession in December 2007, “the number of unemployed persons has increased by 7.6 million to 15.1 million, and the unemployment rate has doubled to 9.8 percent.”

This number does not include 5.4 million long-term unemployed workers who have been without jobs for more than 27 weeks. It does not include 9.2 million involuntary part-time workers. It does not include 2.2 million people who “were not counted as unemployed because they had not searched for work in the 4 weeks preceding the survey.” When added together, the true unemployment rate approaches 20%.

That’s one-fifth of the labor force that cannot be counted on to increase spending anytime soon. That becomes especially significant as the Christmas shopping season approaches. For many retailers, holiday shopping is the difference between success and failure. Weak Christmas spending could easily be a catalyst for a major downturn in stock prices.

Several weeks ago I wrote about how earnings among the companies that make up the S&P 500 index have declined more than 95% since peaking in 2007. This resulted in a price-to-earnings ratio (P/E ratio) of 140.76 for the second quarter of 2009, according to Standard & Poors. For comparison, that is more than three times higher than the previous highest quarterly P/E ratio for the index. This record high level occurred in spite of the fact that most of the companies included in the index met or exceeded earnings expectations for the quarter.

A recent article in ETF Profit Strategy Newsletter commented on the current extreme valuation of the S&P 500 index. It noted: “Historically, a P/E ratio north of 20 is viewed as expensive. Historically, there is almost a 70% chance of correction after P/E levels spike above 25-30. Imagine the impact of a 140 P/E ratio.”

Corporations are just beginning the reporting season for third quarter earnings. No doubt most will again report that earnings will meet or beat expectations. But that is primarily because expectations have been dramatically lowered. For example, Dow component Alcoa this week announced that its third quarter earnings topped expectations. But even though its reported profit of 4 cents per share was better than the forecasted 9 cent loss, it was still significantly lower than the 37 cents a share profit from the same period in 2008. Overall third quarter revenue was down 34% for the quarter. Most individuals, households, or small businesses that suffered a 34% drop in revenue would be forced to make significant budget cutbacks. Yet the financial media is hailing these numbers as evidence that the recession is near an end.

Many readers might be wondering why stocks prices are rising if the economy remains in such dire straights.

One significant reason is that there is no where else for some money to go. Let me cite a specific personal example. My wife is a public school teacher. As a government employee her pension is invested in the markets. Although she has a claim to a share of that money after retirement, she currently has no say in how it is invested. Nationwide, billions of dollars is automatically funneled into 401Ks, pensions, or other retirement plans on an ongoing basis. Virtually all of it is invested into the financial markets regardless of how the markets are performing at any given moment.

The recession and its accompanying economic troubles have eliminated many investment options. Numerous hedge funds have failed or voluntarily shut down. Real estate development has dramatically slowed. Some have postponed starting new businesses until the economy improves. For many investors, putting their money into the stock market is the best remaining alternative.

Virtually everyone is aware that the government has injected trillions of dollars into the economy in an effort to end the recession. Indirectly, some of that money makes its way back into the financial markets. Some is invested by banks and financial institutions. Some comes from the pension funds of companies working on projects funded by stimulus cash.

Finally, when stock prices plunged in 2008, many investors and traders pulled money out of the markets and have remained on the sidelines ever since. As these investors watch the markets continue to rise, many choose to jump back into the markets because they do not want to miss out if the market rally continues.

All this means that in spite of the recession, there is a large pool of money available to be invested into stocks. And as long as there are available buyers, stock prices will continue to climb.

For advisors like Strategis Financial Group and for many individual investors, the rising markets create powerful emotional pressure to jump back into the stock market. But to do so would be irresponsible when fundamental and technical indicators continue to show that the risk of a major correction remains very high.

F.S.

Since bottoming in mid-March, major stock market indices have staged a prolonged rally. The length and steepness of this advance caught many market watchers by surprise, because there was nothing to indicate this was anything more than a typical bear market rally. That perception was reinforced in June when markets posted a loss and technical indicators turned negative. But stocks were able to turn around and resume their climb.

At present, technical indicators are again signaling that stocks could be on the brink of a more significant downturn. It is too early to tell how long or severe this correction will be, but the next couple of weeks could give a clue about what to expect for the remainder of the year.

The chart below shows price performance of the S&P 500 over the past year. Notice how the black line on the chart is rolling over and looking very similar to what occurred in June. The gold line is a 50-day moving average and the index could break below that mark with another day or two of negative market action. If it breaks below that technical support, investors holding long position should consider selling or hedging.

Even if the index breaks its 50-day MA, that does not necessarily mean a significant correction will follow. At the beginning of July the index broke decisively below its 50-day MA only to reverse itself after a few days and climb back above that mark. In hindsight, that signaled a good buying opportunity. But just four months after a 50% correction jumping back in at that point still seemed like a high risk move.

That gives us something to watch for this time. There is strong support at about the 1,000 level. That would be slightly below the 50-day MA. A reversal from that point would probably prompt a buy signal as the index crossed back above its 50-day MA. If the S&P 500 continues to fall below 1,000, we could see a correction lasting several weeks.

The bottom portion of this chart is a relative strength index (RSI). The RSI has already dropped to the 50 level. If this indicator continues to fall it would be a strong indicator of growing market weakness.

The middle portion of the chart is a moving average convergence divergence (MACD). This indicator is still at an overbought level. That means that although the S&P 500 has already had several down days, there is still plenty of downward pressure that could cause it to fall even more.

The next couple of weeks could prove to be important. Some of the biggest down days ever experienced by stocks have occurred in October. Given the current weak economic fundamentals, it would not be unprecedented to see a sharp drop in stock prices. On the other had, stocks could rally again and keep the current upward trend intact. In that case, we should be prepared to take advantage of any investment opportunities.

F.S.

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