Think the market is overbought and ripe for a pullback? You’re right. The problem is, it may not matter yet. Though the rally ’should be’ running on borrowed time, the failure to actually move lower over the last six weeks has given the market ample time to re-establish the underpinnings of the prior uptrend.

And what are those underpinnings exactly? Breadth and depth (or the advancers versus decliners, and bullish versus bearish volume). Here’s a closer look at why stocks may end up continuing to rally in the foreseeable future…. for all the right reasons.

We’ve looked at breadth and depth before, with a detailed ‘how to’ being published on September 11th. If you’re brand new to the analysis, we suggest you revisit that newsletter edition.

As for where things are now, the chart tells the story quite well. Though the recent rally has been said to be ‘flimsy’ and ‘without legs’, the truth is, this rally has been as robust and solid as any other. That’s largely why it won’t die.

Take a look at the ‘breadth’ portion of the chart. This indicates the trend of advancing stocks versus the trend of declining stocks for the NYSE (sorry, the trend length settings are proprietary). The bullish breadth trend line (blue, thin) overtook the bearish breadth trend line (red, thick) in late November after falling under it briefly in early November. Both were outstanding buy/sell signals at their respective times, as they usually are. In fact, a couple of other buy and sell signals are marked on the chart - in yellow - as examples, both of which were also accurate indications.

The depth portion of the chart somewhat mirrors the breadth portion. Since total volume can vary though, while total (combined ) advancers plus decliners can’t, the depth trend analysis is a little more volatile. Still, we can see the bullish depth trend (blue, thin) topped the bearish depth trend (red, thick) in late November, and hasn’t yielded since. A couple of other buys and sells based on depth trend shifts have been marked on the chart as well - both successful, as most are.

More importantly, looking at today’s snapshot tells us that those bullish trends are still intact. That’s why the overall market’s trend has remained bullish at a point in time when it seemed like it couldn’t be. Take a look, but keep reading.

Things can and do change, and these trends will snap eventually. For now, however, it would be wrong to interpret something in such a way that is deliberately contradictory to what the data and its history are saying.

We’ll keep a close eye on the chart and let you know when it starts to change dramatically. Stay tuned.

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The economic saga hasn’t seen many updates in recent weeks, as the year-over-year comps have been mixed (and/or flat) since September. With three months since the stagnation started though, that’s still long enough to spot any new trends… or confirm the continuation of any old ones. Let’s just update the whole shebang in one fell swoop and look at all the important economic data today. We’ll wrap-up with a conclusion and a calendar for the coming week.

Consumer Confidence

We’ve mentioned before that the absolute level of confidence means little to investors - the direction of the trend is the only thing that matters when it comes to the direction of stocks. With that being the case, investors need to be concerned that the Consumer Confidence reading hasn’t gone anywhere (but a little lower) since May. Stocks drifted after that, but the stagnation has caught up with stocks over the last two months. Confidence needs to perk up soon, or stocks are apt to really start to suffer.

Michigan Sentiment Index

The same goes for the Michigan Sentiment Index….

Capacity Utilization

This continues to be one of the consistent upsides to the economic recovery effort… more and more usage of the nation’s factories and shops. Capacity utilization has improved every month since June.

The chief argument against this data is the relative nature of it. At November’s capacity utilization reading of 71.3%, the nay-sayers are right in saying it’s still under the long-term norm around 78%. As was the case with consumer confidence though, the absolute level means little to investors…. the direction of the trend is the key. (Indeed, waiting for the chart to return to 78% will mean a massive amount of market gains left on the table.)

Inflation

Yes, inflation is on the rise. It moved from a low -2.09% (deflation, technically) in July to last month’s reading of +1.84%. Before hysterics set in though, bear in mind that mild inflation is normal and healthy. In fact, the deflationary environment from mid-year was actually a serious threat to the economy. A level of 1.84% is not too cold, nor too hot.

On the other hand, the trend here is alarming. If inflation doesn’t stabilize here but instead keeps skyrocketing, this could be a problem soon. Normally we’d expect the inflation reading to cool off as it got back to normal levels, but this is hardly a normal environment. Interest rates are stuck at abnormally low levels, and the Fed has pumped the economy with lots of dollars…. a recipe for rampant inflation. So far we’ve not seen much, but last month’s surge waves a big red flag. This is definitely something to keep a close eye on.

Unemployment

Do NOT get bullish because unemployment improved last month. In fact, don’t get bullish if unemployment improved again this month. It will take 3 to 6 months to really establish a new downtrend in the employment front. Undoubtedly, we’ll see some ebb and flow on the way down… if it really is on the way down. For right now, we can only grade this chart if the unemployment rate as encouraging (but definitely not definitive).

Payroll data, new claims, and existing claims will also add decisiveness to the overall unemployment rate, since they all wok in conjunction with one another. We’ll drill deeper into that data another time.

Bottom Line

Overall, we continue to see signs of strengthening…. the same signs we saw several months ago. Yet, there are still plenty problems that could turn into impediments. When forced to make a stance though, we have to be cautiously bullish as a whole.

That’s drastically different from the two biggest camps out there right now, which are (1) blindly bullish at all costs, and (2) certain the economy is going to implode in the near future…. two dangerously extreme opinions. From an unbiased, scientific (based on history) point of view, the data says cautious optimism is justified…. and likely fruitful for investors.

Here’s last week’s data, and what to expect this week.

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We’ve talked around it a few times since March’s bottom, but haven’t had much need to actually put the sector rotation principle into action…. until now. As the second wave of the bull market starts to cool off though, we can see - literally - there’s a shift in the market’s sector winds.

Sector forecasting is a never-ending analysis, and as of the time this is being written, all sectors appear to be headed lower (see the S&P 500 index forecast here). When the next leg of the bull market starts though, it looks like some of the prior hot spots will be cold, and some of the prior cold spots will be hot (with a few luke-warm patches).

So, here’s a look at our early 2010 sector expectations (the basis and chart is below). It should be good for a few months, with minimal changes.

Cooling Off (stocks that are no longer ‘must haves’, and perhaps becoming ‘don’t wants’)

• Financials - They’ve made the least progress of all, despite some considerably stronger results. They’re already trading on 2010 earnings, which are apt to be mediocre.
• Materials - We hate to shed a group that has exhibited good momentum, and a group that’s an inflation hedge. But, the momentum is fading, and inflation hasn’t surfaced anyway.
• Energy - This is the fastest falling group on the board right now, and the dollar’s new uptrend isn’t helping any.

Heating Up (the market’s next big things)

• Utilities - The next-to-last performers so far are starting to inch higher now.
• Telecom - A ‘rags to riches’ story unfolding… the group found no love for months, but are accelerating better than any other sector now - the biggest potential recovery plays for the next several weeks.
• Industrials - They were never in trouble; they’ve actually done pretty well. They should continue to do well in the foreseeable future.
• Cyclicals - As a group, they’re mediocre; we recommend cherry-picking some of the better names from the moderately-gaining sector.
• Technology - Like the industrials and cyclicals, slow and steady will work just fine.

Take ‘Em or Leave ‘Em

• Healthcare - Unless there’s a clear reason for an exception, the group has been persistently lethargic.
• Noncyclicals - The consumer staple names have been lost in the shuffle, but aren’t apt to be found anytime soon when there’s so much other stiff going on. They aren’t a liability, but their very nature…. they’re just not waiting to fly either.

The fundamentals may or may not support the outlooks, but that’s a layer of detail we’ll have to add sector by sector in future blog posts. Stay tuned for those - we’ll add them in order of importance and relevance.

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Though we’ve not had a chance to mention it yet, Tuesday’s loss of about 1% has finally prompted us to take an important look at a short-term chart that has implications for even long-term investors. How so? If the S&P 500’s pattern repeats itself for the fourth time over the course of December, we’re all on the verge of riding our stocks lower… to the tune of more than 5% off of current levels. Earth-shattering? Nah, but nothing to blow off either. Here’s a closer look.

Technical analysts talk about them occasionally, but rarely do you actually see one of this quality. What we’re talking about are arcs – bowl shaped trend lines that in this case are providing support as well as resistance for the S&P 500.

The chart below pretty much says it all. The slope of the bullish trading range has all but flattened… a drastic change from the steep slow we saw when the market rebounded in July. In fact, the market’s gone nowhere since hitting the ceiling in early November – a testament to just how strong these arc lines are.

If the pattern repeats itself (and that’s always a big ‘if’), then the index should make its way back to 1035 before too long.

There is a bigger risk than that, however. A move of that magnitude would mean the market hadn’t made a net gain since September… and impatient investors may decide to chuck stocks altogether, pulling them under the lower arc line. If that happens, look out below. There’s no telling where things may land. Needless to say, we’ll be watching closely when/if the time comes. In the meantime, just be aware of the kind of hurdles the market’s not been crossing.

By the way, the other major indices aren’t showing us quite the same shape (the arcs), but they are showing us the same basic idea – the buyers are getting tired, and need a break.

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