The Unexpected is Worth Watching

The big picture remains that of shares that are discounting a continued recovery in jobs and incomes for the second half of the year.

That's something that the market has been telegraphing for quite some time, all the while confounding those who have been skeptical of even the existence of a bull market.

Short-term, the averages are technically overbought to a degree seldom seen.
For example, the PowerShares Trust QQQ Series 1 (Nasdaq: QQQQ) has stood above its 10-day moving average for 42 days in a row, the most since the ETF was conceived in early 1999, and well past the previous high of 28 days. Along these lines, we would note that the unexpected is what is worth paying attention to, and in particular, any sort of message that this -- the market's extreme resilience -- may be giving.

The message is believed to be all about the U.S. economy, i.e. that it will prove stronger in the second half and into 2011 than is commonly expected. By the time this is widely accepted, we believe further upward revaluation will have taken place.

We have witnessed this many times, a number of which have been chronicled in this space, beginning in 1996. The message is never known at the time; this is due to the market's discounting mechanism, which prices its outlook for the next six- to- nine- to perhaps as much as 12 months into today's prices. This forward-looking mechanism is why general market analysis based on today's fundamentals alone makes it difficult to stay ahead of the curve and anticipate trends.

One favorite forward-looking indicator is the action of retail stocks. Since retail sales comprise about one-third of the economy, an index of retailers can provide a valuable look at the market's expectation for consumer spending, itself about 70% of gross domestic product. Indeed, the solid outperformance of retail stocks beginning in November 2008 was one contributor to our April 19, 2009 report that a brand-new bull market had begun on March 6, 2009.

The chart below also shows how retail stocks began seriously outperforming the Dow Jones Industrials on Jan. 19. This has provided us with confidence that a double-dip recession is not in the cards.

Of import has been the buoyant speculative sentiment. This is important because risk-taking goes hand-in-hand with a healthy market. What you want to see are the higher-risk segments such as the materials, aggressive growth stocks, and recent new issues performing better than their lower-beta, or lower-risk, counterparts. If the reverse occurs, and less-risky segments begin to outperform more-speculative areas, the result is a more defensive, cautious market.

One example of the speculative sentiment is the better showing by riskier segments vs. the Industrials since the Feb. 5 market low. Whereas the Industrials have returned better than 10%, a step up the risk ladder shows small- and medium-capitalization indices, as well as emerging markets ETFs for China and Brazil, all gaining in the 16% to 19% range post-Feb 5.

Moving even further up the risk ladder, one passes the Russia ETF at 21% since Feb 5. At the top of the ladder sit some of the higher risk names, though with correspondingly higher return potential: the coal, and steel ETFs. These are up 25% to 30% since Feb 5.

Not surprisingly, in light of the extended nature of the averages, the intermediate-term speculator, who seeks to hold a winning position for several weeks to several months, is faced with precious few fundamentally sound stocks that are not extended above their most recent bases, or areas of technical support. Therefore, a pullback in shares would be welcomed, as it would reset the price patterns of many stocks, creating new opportunities and potentially better, lower-risk entries.

One stock with sound fundamentals that is believed to be en route to richer quotations is (Nasdaq: MELI the Latin American version of is expected to record quarterly earnings estimates of 51%, 47%, 32%, 20%, 34%, 23%, 21%, and 26% over the next eight quarters, according to Thomson First Call. Revenue forecasts are even stronger, anticipated to be in the 43% to 49% range during 2011. Net margins have strengthened from the low-teens to the low-20s on a percentage basis in the past few quarters.

Ninety-four mutual funds owned the stock at year-end, an increase from 62 a year earlier, and reflective of the growing institutional interest, a plus. The stock is about three-quarters of the way up the right side of its basing pattern after rising from about $8 to $55 since late 2008. Value investors need not apply: The shares have a high price-earnings ratio, which is usually the case for an emerging growth title with leadership credentials in a bull market.

In summation, intermediate trend, breadth, and leadership are positive, while short-term the averages are extended. Given the unusual degree of the averages' overbought posture, some backing and filling is anticipated in the short term.

Shares' care-free "what, me worry?" attitude may strike some as off-base, given high unemployment, the potential for higher rates, sovereign credit risk, and other worries du jour. However, to ignore the market's technical underpinnings, particularly those which have functioned as leading indicators for countless bull markets, is to ignore the way the market has actually worked since its inception.