| As is always the case with the stock market, if one looks closely enough, one can find enough evidence to make a bullish or bearish case for the market. These days are no exception.
The Good News
Most of the good news surrounding the stock market today comes from longer-term perspective indictors. What this means is that the indicators do not necessarily predict or forecast what will happen in the near term. They are simply useful indicators for determining the probabilities of a major advance or decline in the market.
The primary favorable factors at present include long-term seasonality and the relative value of stocks versus bonds. Chart 1 displays the typical historical performance of the stock market during each of the last 10 decades, year-by-year. 
Chart 1: Dow Decennial Pattern
A few trends are fairly clear:
- The Dow tends to start each decade with a decline that bottoms out somewhere between the middle of the “1” Year and the middle of the “2” Year.
- The market then tends to rally strongly into Year “6”, with an exceptionally strong performance during Year “5”.
- The market tends to suffer a decline starting sometime in Year “6”.
- The market tends to make an important bottom in year 7 and then advance toward the end of the decade.
Although not every decade works exactly as the pattern previously described indicates, this roadmap has proven to be quite useful time and time again. And, interestingly, this decade has, so far, followed the roadmap quite closely. The market suffered a sharp decline from early in 2000 into the middle (actually just past the middle) of 2002. Since that time, the Dow has moved higher, having now paused in a trading range for the last 16 months. If history does prove to be an accurate guide, we should expect higher stock prices by the end of 2005. As I have mentioned in the past:
- No year ending in “5” has ever experienced a loss.
- Despite this fact, no one should assume that the market “has” to move higher. The proper way to view this piece of historical information is simply to give the bullish case the benefit of the doubt.
The second favorable perspective indicator is the well-known “Fed Model”, which compares stock earnings to bond yields to assess whether stocks are overvalued or undervalued relative to bonds. 
Chart 2: Fed Model: Relative Value of Stocks versus Bonds (Source: Yardeni.com)
Just as with the Decennial roadmap in Chart 1, the Fed Model is not something that can be used to “pinpoint” turning points in the market. Still, extreme readings -- both high and low -- have been extremely useful in the past. The low readings between 1979 and 1982 presaged the start of the great bull market run that began in 1982. Extreme low readings between 1993 and 1996, and again in late 1998, were accompanied and followed by the great bull run of the 1990s. Finally, the 2002 - 2004 advance started with the Fed Model in extremely undervalued territory, where it essentially remains today.
On the other end of the spectrum, the extreme high reading in 1987 ended with the Crash of October 1987, when the Dow plunged 22% in a single day. Likewise, the devastating 2000 - 2002 bear market followed the extreme high levels reached in 1999 and 2000. That bear market saw the Nasdaq decline more than 75% from peak to valley.
Even the most unsophisticated investor would have no trouble discerning on which side of the fence this indicator is presently resting. At the bottom of the 2002 decline, the Fed Model fell to a 23-year low and today remains far into bullish territory. So, does this mean that the next big rally is just around the corner? Unfortunately, the answer to that question is “not necessarily.” As I mentioned earlier, the Fed Model is not a “timing” indicator. The proper way to interpret the present Fed Model reading is simply this: The probabilities strongly suggest that stock prices will advance sharply sometime in the next 1 to 2 years, so give the bullish case the benefit of the doubt.
The Bad News
The bad news at the moment primarily involves several market breadth measures, as well as several cyclical or seasonal factors.
One problem with seasonal analysis is that, just because a particular time frame, or month or series of months has an historical “tendency” to move in a particular direction, does not mean that that is what will happen this time around. Still, based on several historical seasonal factors, it is tough to get excited about the prospects for the stock market during the next few months. Consider the following:
- Since 1886, the month of May has witnessed an average decline of –0.12% during the month. The market has been up 61 times and down 59 times. In a nutshell: If ever there was a month that qualifies as a “tossup”, it would have to be the month of May.
- May is followed by the summer months of June, July and August. While I have often heard talk of a “summer rally” in the stock market, I haven’t seen a lot of evidence of it. Chart 3 (shown subsequently) displays the growth of $1,000 invested in the Dow, only during the months of June, July and August, every year since 1950.
Along the way, there have been some pretty good rallies, some harrowing declines and a lot of chopping around. In a nutshell: The summer months have been “dead money” time for the stock market. During these three months, over a 55-year span, the market has gained a total of only approximately 4.5%.
Chart 3: Growth of $1,000 Invested Only during
June through August Each Year since 1950
So, based on the experience of the past 55 years, it would seem to be a little difficult to get excited about the prospects for a major stock market advance between now and the end of August.
So, what's an investor to do?
I, for one, am a believer in always keeping some money in the market generally focused on the top performing industry groups and sectors. Beyond that, a cursory glance at the market these days seems to give one a gloomy feeling. Interestingly, if you look at the actual numbers, the economy is doing relatively well. However, it does not “feel” as though it's doing very well.
High energy prices, rising interest rates and lousy market action appear to be taking a toll psychologically. And, given the facts that many market averages are presently below their longer-term moving averages, that market breadth is very poor at present, and that new lows regularly exceed new highs, there is much to be said for exercising caution. Still, before anyone cries, “The sky is falling" and sticks his or her head in the sand, I believe he or she should look again at Charts 1 and 2 in this article and ask, “Do I really think a major decline is in the offing?”
My advice: Keep some powder dry, but don’t stick your head in the sand. If some catalyst emerges in the months ahead -- the Fed stops raising rates, crude oil declines sharply, jobs growth continues strong for several months, etc. -- don’t be surprised if the market moves higher by the end of the year. |
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