It was quite the party, but it looks like the latest and greatest bear market sucker’s rally may have finally run its course.  To be sure, a few days of market weakness don’t necessarily sound the death knell for a 6-1/2 month rally, but on both the technical and fundamental fronts, it appears that months of ominous developments have finally come to a head.

Recently the S&P 500 broke out of its 960-1015 trading range, but the current situation looks rather dismal. As I’ve recently discussed, the lack of upside momentum and the belabored manner in which the market climbed since late August were ominous signals.  The market should have surged higher following the breakout above 1015 but instead it struggled higher. As I’m fond of saying, when what should happen doesn’t happen, the opposite becomes likely. 

And indeed the opposite is occurring. Last week the S&P 500 suffered significant short-term technical damage which, combined with the lack of upside follow-through suggests that at least a larger correction is imminent and possibly that the “mini-bull” market has run its course. Let’s take a look at the growing list of bearish indications:

1. Follow-through on the breakout above 1015 was dismal. The S&P 500 managed to extend its uptrend by a mere 25 points. In a healthy uptrend we want to see a lot more progress than that in a breakout from a 2-month consolidation area.

2. The S&P 500 took three laborious weeks to gain those 25 points and undid all of the progress within a mere four sessions. In a healthy uptrend the market should have an easier time rising.  But it looks like the path of least resistance is now down; the market struggles with gains but skids lower almost effortlessly.

3. The recent move under the low of 1007.71 violated important short-term support. A healthy uptrend shouldn’t violate former lows.  In and of itself the violation is not necessarily bearish; it’s part and parcel of healthy corrections. But the violation of a low in the wake of a weak advance is bearish.

4. The market is back into the former trading range. Return-moves to the breakout level are common, but with only 25 points of upside follow-through, the move back into the trading range is yet another indication of weakness.

To be sure, one bad week doesn’t necessarily nullify a half year of gains; the intermediate-term uptrend is still intact.  The factors listed above serve as warnings, not conclusive indications of a major change in trend. 

Nonetheless, we have to ask ourselves “Is this the kind of market environment I want to risk my capital in?” In my estimation the answer to that question is a resounding “no”. When I invest my capital I like to see strength. I like to see follow-through. I like to see determined movement. I don’t like to see hesitation, stagnation nor “warning signs”. I like the sure thing, or as close to the sure thing as I can get. When my money is on the line, weakness and uncertainty make me nervous.

What is conspicuously absent from the market’s price action is confidence.  Instead we see uncertainty and hesitation. Again, that doesn’t necessarily indicate a definitive end to the uptrend, but conditions are not sufficiently clear nor bullish to justify putting a substantial amount of money at risk.

Ominous conditions are arising on the fundamental front as well. First off, the market is vastly overpriced. That’s been the case throughout the entire bear and obviously, a higher stock market does nothing to alleviate overpriced conditions. 

Currently the p/e ratio of the S&P 500 stands in the mid-30s. I don’t have to tell you that this kind of pricing is more appropriate to bull market upper extremes than to the early stages of a bull. And forget all that hoopla about “trailing earnings vs. projected earnings.” Projected earnings are the figment of the incessantly bullish imaginations of pencil-pushing analysts. Projected earnings can’t be spent on increasing production, building factories, research and development, marketing, etc. The only earnings that count are those that have been booked and banked.

Additionally, market participants are overly bullish. A recent AAII poll of individual investors revealed that bulls outnumber bears by a factor of greater than eight to one! An astronomical 71.4% are bullish compared to a mere 8.6% who are bearish. Meanwhile, according to Investor’s Intelligence, 54.1% of investment advisors are bullish while a scant 19.4% are bearish.   Most investors and investment advisors fail to beat the market- you want to be on their side?

As if that wasn’t enough, insiders are selling stock at record levels. According to Investors Intelligence, corporate insiders are selling more than 4.5 times as many shares as they’re buying. A 17-year record.  Thomson Financial reported that in July insiders sold more than $32 of stock for every $1 they bought. 

What do you suppose it means when the folks most intimately aware of what’s going on at their companies are selling their shares? Who sells their shares when they’re confident of higher prices? No one. You do the math.

Is heavy insider selling something you’d expect during the early stages of a developing bull? Of course not. Mark Hulbert informs us that at the bottom of the 1973-1974 bear market the ratio of selling to buying stood at 0.92. Insiders were buying more than selling. Following the 1987 crash, the ratio stood at 0.56. Again, insiders were buying more than selling. Almost two times as much. Today that ratio stands at greater than 4.5. Sound like a bear market bottom to you? Sound like insiders are bullish on their own companies’ prospects?

Another disturbing factor:  the NASDAQ composite has risen more than 70% off its bear market low, while the S&P 500 has risen about 35%. What does that tell us? That investors have flocked back into tech stocks like there’s no tomorrow.

Why do I find that disturbing? Because tech stocks led the last bull market and yesterday’s leaders do not lead subsequent bull markets. Leadership changes. In fact that’s sort of a requirement of major bull markets: some new thing, some new “hot” sector that gets people excited and raises optimistic hopes for the future. The fact that yesterday’s leaders are leading the pack once again suggests that this uptrend is just another bear market rally.

Combine that with the fact that insiders are heavy sellers and you can draw one obvious conclusion: the market is undergoing distribution. The smart money is distributing, or unloading stock on the dumb money. The dumb money being, of course, small investors who think the good old days of easy technology profits are upon us once again.

At bear market bottoms you tend to see just the opposite: accumulation. The dumb money bails out, hoping to save what little capital they have left, afraid of sitting through more losses. Meanwhile the smart money quietly accumulates those shares at bargain prices. Which, as we saw in Mark Hulbert’s numbers discussed above, is exactly what happened at the lows in 1974 and 1987. Clearly we are NOT witnessing accumulation (which marks bottoms) today and the insider selling data makes a strong case for distribution (which marks tops).

Let me douse the bull’s parade with a bit more rain. Richard Bernstein, chief U.S. strategist at Merrill Lynch recently published a report with some very interesting revelations. I’ll spare you the gory details and get right to the conclusions:

1. The most actively traded stocks in the S&P 500 are currently trading at a 15% premium to the market. Historically, at the beginning of past bull markets, the most active stocks have traded at discounts to the market.

2. Investors today prefer lower-quality stocks, those lacking stable growth, earnings and dividends. My interpretation: Folks are chasing after junk. That’s called “speculation” and it’s not the kind of investment that fuels bull markets. Speculation is what we expect to see in the later stages of a bull market, not in the beginning. Early in a bull market investors tend to be cautious, after having been burned in the preceding bear market.

So there you have it. Market valuations, the behavior of small investors and the actions of corporate insiders are all consistent with what we’d expect to see in the later stages of protracted bull markets! This is not the kind of stuff we want to see in the early stages of a real advance. 

And what of all that “better than expected” economic data we’ve been hearing about? Hogwash.

1. Expectations have been lowered to such dismal depths that some of the data had to eventually surprise on the upside. When you’re expecting the apocalypse, a tornado and a few hailstorms are actually a welcome relief. The fact that some of the economic data has been improving does not necessarily signify a turning point nor a reversal, just like a bear market rally does not imply a new bull market.

2. The economy has bled 2.7 million jobs in the past few years, 1 million since the “recession” ended in November of 2001. I don’t care what’s “better than expected.” If you don’t have a recovery in jobs, you’re going to have a very hard time sustaining an economic recovery. Recoveries are supposed to create jobs. If you don’t have job creation, you don’t have a recovery. A recovery in government statistics is not the same thing as a genuine economic recovery.

Mark Zandi, chief economist at Economy.com recently stated “This recovery is being juiced up by fiscal and tax cut stimulus. But if we don’t get more job growth by the end of this year, it will almost certainly peter out. And then we’re out of options.”

Here’s the bottom line: the numbers might be looking a bit better but a recovery is not happening. And whatever improvement is happening is not carrying the weight of job growth. Without job growth, don’t expect the economy to genuinely improve. And without genuine improvement, don’t expect a sustainable bullish market trend.

© 2003 Mark M. Rostenko
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