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Back in the day, a guy or gal totally immersed in the financial markets ("Hi, my name is Jay") could pretty much just put his or head down and ignore politics completely and even to an extent, economics, since - let's be honest here - no one has ever really figured out how to accurately time tomorrow's market using a 6-month economic forecast. So for the most part you could just focus on whatever trade signal generating method you felt was best and have at it. Politics and economics was just so much "same old, same old." Maybe the tenor of the times was pro-business, maybe not so much. Whatever. Ah, those were the days, my friend. Nowadays it is a lot harder not to pick your head up, take a look around and then, well, fight the urge to curl up in a ball.

Much of this new angst appears to stem from the fact that for the first time in our lifetime there seems to be a sense among many individuals that capitalism itself is under attack, and not just from the radical fringe, but from the highest levels of power in the U.S. Now if you are a Democrat and/or an Obama supporter, please do not take that as a partisan political jab - this is a financial column, not an op-ed piece. I am merely pointing out the fact that there is a perception among many that there has never been a time when people who "produce" have been under as much attack for "making too much" (silly me, all along I thought that was the idea).

In addition, for a number of decades we have been told that government spending is "out of control" and that the national debt is "too high." And so on and so forth. And while we heard all the warnings of the ultimate calamitous ruin that awaited, for the most part what the investing public heard was "blah, blah, blah." Then in 2008 we saw firsthand the effect of spending too much money, taking on too much debt and general fiscal irresponsibility as Fannie Mae and Freddie Mac collapsed and the great housing bubble burst. Likewise, the entire banking system might also have imploded had the Fed not "primed the pump" and simultaneously also dropped short-term interest rates to near zero. And for a brief moment it seemed that perhaps we had weathered the storm.

Then, in a disturbing subsequent turn of events, the federal government apparently determined that the answer to too much spending and too much debt is - and please remember that they are way smarter than you or I - even more spending and a huge increase in debt. Who would have guessed?

American Public: Is this any way to deal with a fiscal crisis?
Washington: Well, it's one way.

Anyway, I've already grown weary of talking about politics and economics, so if you want some interesting information regarding one effect of spending in the financial markets please see this excellent piece at Optionetics.com from January 4, titled "Commodities Roundup: Gold."

http://www.optionetics.com/market/articles/22163)

In any event, the main point is that despite the fact that the stock market has advanced over 60% since the March 2009 lows, there remains a tremendous amount of angst surrounding the financial markets, as a large segment of the investing public seems to be waiting for "the other shoe to drop." So let's try to take a reasoned approach to what exactly is going on to see if we can dispel - or as the case may be, enhance - the current level of paranoia among the investing public.

IT'S ALL IN HOW YOU LOOK AT IT

As everyone knows, some people are "the glass is half full" kind of people and others are "the glass is half empty" kind of people. This definitely holds true for individuals looking at the stock market these days.

So under the category of "a little something for everyone," here are four key things to keep in mind as things move forward:

1) Good News: The stock market knows all (usually).

On the one hand, it has been said that the stock market has correctly forecasted 12 of the past 9 recessions. On the other hand we must always remember that the stock market is a "discounting mechanism", which simply means that it anticipates changes in the economy well in advance of actual events. As such it has a much better historical record of forecasting the economy than an ocean of economists. In August 1982 the stock market began an astounding rally as talk of an impending "Depression" was rampant. Likewise, the stock market bottoms in 1974 and 2002 were accompanied by great pessimism. The 2009 low was accompanied not so much by pessimism as it was by out and out fear. If it is true that the stock market bottoms out and begins to look ahead when things presently look their worst, then it makes perfect sense to argue that the 2009 low was a significant bottom and will not likely be revisited anytime soon.

2) Good News: The trend is presently inarguably "up."

Also working in favor of the bullish camp these days is the age old adage "the trend is your friend." In Figure 1 you can see the Dow Jones Industrials Average with the 50-day and 200-day moving averages plotted. Historically, a move of the 50-day average above the 200-day average has been a very favorable sign for the stock market (and vice versa).

It should be pointed out that there is no forecast built into trend-following indicators, only, well, "indications." In other words, while "yes" the trend is "up" as of today, this does not mean that things can't turn down starting tomorrow. Still, when something has a good track record for 70+ years it is typically a good idea to give it the benefit of the doubt. As such, investors should keep an eye on this simple measure. As long as the 50-day holds above the 200-day then the trend is "up" and there is no reason to allow the present days news to cause one to panic.

Figure 1 - Dow Jones Industrials Average (50-day moving average above 200-day moving average)

3) Bad News: There are some actual problems

On the flip side, there is this gnawing feeling that the macroeconomic problems that we face today - soaring debt, questions about the creditworthiness of treasury debt, the prospects for sharply higher taxation and soaring inflation and remaining doubts about residential and commercial real estate - are problems that are at long last "coming home to roost" and that things could conceivably get much worse economically speaking in the years ahead.

During the past twelve months is the first time I can ever remember serous talk questioning "the creditworthiness" of treasury securities. As such, it seems more rational than ever to keep an eye on economic developments - debt, spending, economic growth, taxation, unemployment, etc., and to look for some confirmation of the improvement that the stock market seems to be telling us "should" occur in the next 12 months. If we do not see actual evidence of economic improvement (and I am talking here about "actual improvement", and not the "and economists were surprised that unemployment rose only x% last month" type of "good news" that we've grown so accustomed to) in the months ahead, our present paranoia may prove sadly prescient.

4) Bad News: In terms of the "big picture" the market still has quite a ways to go.

As I mentioned earlier, some people "see the glass as half empty." As great as the rally has been in the last ten months, it can be argued that the Dow has merely retraced a little over 50% of the 2007-2009 decline. The fact that it has been able to overcome that resistance area (as you can see in Figure 2, the Dow spent a number of weeks bouncing around near the 50% retracement level) is a good sign. Still, like the 50- and 200-day moving averages, investors should keep a close eye on the level of the Dow. A move back below the 10,330-10,370 level would suggest that the bulls have taken their shot for now and were unable to keep the Dow moving higher.

Figure 2 - Dow has retraced a little over 50% of 2007-2009 decline. Will this level hold?

Now the "half full" people will look at Figure 1 and see a market that took a huge hit, discounted the bad news and is now rallying in anticipation of better economic days ahead. The "half empty" people will look at Figure 2 - which for the record, displays the same underlying bar chart as shown in Figure 1 - and see a market that has done nothing more than retrace 50% of its previous decline.

The same bar chart, two equally defensible opinions. In the immortal words of Crosby, Stills and Nash, "Paranoia, it strikes deep."

SUMMARY

It is good advice in general - and especially as it relates to the stock market - not to give into your worst fears. In most cases, doing so can cloud your thinking and lead you to misguided decisions. At the same time, if you are flying in a plane and notice that the engines have cut out, sure you could simply put your head between your legs (personally, I don't want to be found like that) or you could be a tad more proactive and inquire about - nay, demand - a parachute. For the past 10 months the flight has been quite smooth and investors who have been in on the stock market rally over the past ten months have been on the right side. Unfortunately, unlike a sporting event, there is no "end" to the game. It goes merrily on. As such it is left to each of us to decide if and how to participate. Investors should resolve now to take action if the "engines cut out" in the days or months ahead.

So here is my thinking in a nutshell: for now, the trend is "up." As long as it continues to be "up", I will play the market from the bullish side. At the same time I still harbor paranoia that a "day of economic reckoning" may be out there still. As such, if the market starts to "roll over" - i.e., if the 10,330-10,370 support level fails to hold and especially if the 50-day moving average drops below the 200-day moving average I will not hesitate to adjust accordingly to a bearish stance.

So the key is to avoid being paranoid, to objectively keep an eye on the evidence and to react accordingly to changes in the evidence. Until then, in the immortal words of Kevin Bacon in "Animal House" - "all is well."

OK, now I'm paranoid again.

FOLLOW-UP ON SMALL-CAP VERSUS LARGE-CAP

Before the holidays I wrote about the propensity of small-cap stocks to outperform large-cap between mid-December and the end of the following February. So far, so good this time around. Since the close on December 15th, the Russell 2000 small-cap index (RUT) is up +5.3%. During the same time, the Russell 1000 large-cap index (RUI) is up +2.7%.


Jay Kaeppel
Staff Writer and Author of Seasonal Stock Market Trends
Optionetics.com ~ Your Options Education Site

Questions for Jay? Please visit "Ask the Traders" through the discussion board on the Optionetics.com home page.

NOTE:

Jay's latest book, Seasonal Stock Market Trends: The Definitive Guide to Calendar-Based Stock Market Investing, was ranked among the Top 10 Investment Books for 2009 by the venerable The Stock Trader's Almanac 2010. For more info, please click here.

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