What’s the Long-term Outlook for Stocks?

The market hasn’t gone anywhere for over 6 weeks and there’s been no trend or follow through to either up or down moves. Periods of stagnation are often followed by bursts, either up or down.

If you’re an avid reader, you’re probably familiar with analysis paralysis � the more you read the more complex and less clear the picture gets.

Below is a concise summary of potentially market-moving bullish and bearish trends and currents. Combine those with trigger levels for the major indexes and you have an action plan that should slice through the muddy view.

Economic News

We are getting bombarded with economic news and stats everyday: housing starts, mortgage apps, industrial output, cpi, ppi, manufacturing index, consumer spending, etc.

It’s not scientifically accurate, but the consumer confidence index more or less reflects the change of the sum of economic indicators. The chart below plots the S&P against the Consumer Confidence Index since 1999. The correlation between consumer confidence and stocks is pretty straight-forward.

The question is, does consumer confidence (and economic statistics) lead or lag the stock market?� Wall Street considers them a leading indicator and a legitimate forecasting tool.

I disagree. Here’s why:� Confidence is a reflection of sentiment, and bullish sentiment, when at an extreme, tends to be a net negative for stocks.

Here’s an example of what Wall Street and the media said right before the market crashed 20% in April 2011:

“Leading U.S. indicators, consumer confidence gain as fuel costs discounted” � Bloomberg

“World revs up profits” � Wall Street Journal

“GE CEO Immelt says global economy is improving” � AP

Using consumer confidence and sentiment as a contrarian indicator rather than a leading indicator and combining it with technical analysis, the ETF Profit Strategy Newsletter came up with this contrasting forecast in April 2011:

“Even though odds do not favor bearish bets the first half of April, I believe a major market top is forming. S&P 1,369 � 1,382 is a strong candidate for a reversal of potentially historic proportions.”

Despite � or more accurately because of � optimistic sentiment, the S&P peaked on May 2, 2011 at 1,371 and spiraled down 20% thereafter.

Seasonality

“Sell in May and go away” is almost upon us and it worked like a charm in 2010 and 2011. It might be too much to expect an exact replica here and now, but the fact is that stocks tend to under perform during the summer period.

Longer-term seasonalities suggest quite a roller coaster market ahead. The summer doldrums are balanced by the election year cycle, which is the second strongest of the 4-year Presidential cycle.

The incumbent administration does what it takes to get re-elected (monetary stimulus via the Fed, promised but undelivered law changes, tapping into the national oil reserve, etc.). Once the election is over, there’s no motivation to ‘bribe’ citizens or earn goodwill, and stocks tend to take a breather in the post election year.

Combining Economic/Seasonal Data with Trigger Levels

Economic reports have been improving, although this can be expected because the economy was so bad it had nowhere to go but up. Short and long-term seasonality is bearish with bullish potential sandwiched in between (later this year).

How do you manage your portfolio based on this information? It helps to add some technical analysis to the mix.

Right now, the S&P is suspended in a technical vacuum. That means it’s stuck below up side resistance (represented by various Fibonacci levels and a trend line going back to 2002) and support.

The Dow has fallen below short-term support but remains above longer-term resistance, the same is true for the Nasdaq Composite� and the Apple (NASDAQ:AAPL)-heavy Nasdaq-100 (NASDAQ:QQQ).

Support/resistance based risk/reward analysis shows that the risk to the down side is greater than the reward to the up side. A drop below support will trigger the down side risk.

To understand the implication of broken support, it’s important to know how support/resistance (S/R) levels works.

Understanding How the Market Works

S/R levels are like subway stations. Although a subway can stop anywhere, it is most likely to stop at a station.

The October 2, 2011 ETF Profit Strategy update identified S&P 1,088 as the ‘station’ likely to stop the decline and send stocks higher. Here’s the exact wording of the October 2 update:

“Based on the data we have, it’s prudent to scale down short positions around 1,100 and exit most short positions around 1,090. Buy after the S&P registers a new low (around or below 1,088) and comes back up above resistance at 1,088 and/or 1,121.”

The S&P reversed directions after an intraday slide below 1,088 and rallied strongly thereafter. I personally thought that the S&P rally would stop around 1,369, the next major resistance.

But the market cares little about what I think, that’s why I have to care about the market’s inner workings, and the market works in terms of S/R levels. If you understand S/R levels, you are a giant step closer to understanding the market.

The March ETF Profit Strategy Newsletter stated that: “A break above 1,369 would unlock more bullish potential with 1,425 as a potential target.” Since the S&P didn’t stop at 1,369 it was likely to keep going. The S&P hit 1,422 on April 2 and has been stair-stepping lower since.

This stair-step decline has brought the S&P perilously close to must-hold support. A break below support would lead to lower prices and possibly trigger a nasty decline like in 2010 or 2011.