Why Investors Should Exercise Extreme Caution

Tuesday, both the Dow Jones Industrial Average and the S&P 500 closed above psychologically important barriers. For the Dow it was the 12,000 mark and for the S&P it was 1,300. But the climb to new highs held more than psychological significance since it reversed what appeared to be a negative technical signal on Friday, and set the stage for further gains.

What the Markets Are Saying

Despite an overbought market condition, rising oil prices, and Middle East governments in chaos, stocks rallied to new highs. The threats to the political stability of Egypt, Jordan, Yemen and even Saudi Arabia were ignored as investors focused instead on an improving U.S. economy. The report that triggered the buying was the Institute for Supply Management’s index of manufacturing activity, which rose to levels not seen since May 2004.

As unlikely as it seemed, the Dow’s January peak of 12,020 was overcome by noon. And so now the focus turns to the S&P 500 since, even after smashing the barrier at 1,300, it must crush the overhead that dates from August 2008, at 1,313. This is the line that most technicians mark as the beginning of the major bear market that ended in March 2009. And many are of the opinion that the penetration of it could lead to another rush to buy stocks.

Admittedly the March 2009 number, a technical barrier that is two and a half years old, may only have significance to finicky technicians. But the current significance of the world’s dangerous political scene cannot be ignored. And yet U.S. stocks are pushing ahead in complete disregard of what could lie ahead.

What should we do when markets rally in the face of such overwhelmingly bad news? Should we cast aside our normal technical tools and just go with the trend or stick with the methods that have historical accuracy?

In mid-December, when I announced my annual targets, many readers thought that they were overly optimistic by a wide margin. But in less than six weeks, the Dow industrials are a mere 760 points (6.3%) from that goal, and the S&P 500 is only 92 points (7%) away from it. The irrationality of a run of this magnitude on volume, which is puny by any standard, should jolt us back to reality. The world’s largest stock market is being controlled by just a few buyers. Meanwhile, other global markets, and especially emerging markets, have failed to keep pace, and our own Dow Jones Transportation Average is in a confirmed short-term downtrend.

Mark Arbeter, S&P’s chief technician, said, “Despite the hoopla over the DJIA crossing 12,000 and S&P 500 breaching 1,300 this week, we see mounting cracks in the dam. Many indices in the U.S., as well as globally have failed to follow the DJIA and S&P 500 over the last week, and we see this as a major warning that a pullback or correction is near. In addition to the non-confirmations by many indices, we are also seeing plenty of divergences with respect to market internal data. At the same time, price momentum is overbought on a daily and weekly basis, and market sentiment is tilted very heavily toward the bullish camp. This, to us, all adds up to a 5% to 10% decline in the major indices over the next month or two.”

With the exception of very quick bullish trades, I suggest extreme caution. When this market turns south, there will not be enough room to accommodate those seeking the exits.