Looking Behind the Bounce

This has certainly been a powerful rally off the September lows. From trough to peak in just under three months, the Dow Jones Industrial Average and S&P 500 were up more than 20%, with the real spotlight again on the tech-heavy Nasdaq, which was up more than 40%. That must have changed the trend of the market, right? Wrong!

As regular readers know, I'm bullish, not bearish on the market, because I believe the economy should recover in 2002, and stocks should outperform bonds and cash instruments over the coming year as a result. It won't be an easy environment; the major market indices may basically go sideways with an upward bias until the fundamentals have time to catch up to the valuations.

If you look at the three major market indices, they have not only reached a short-term overbought condition but are overbought on an intermediate-term basis as well. In an uptrend, that would be a positive, but as the charts show, the markets are not in an intermediate-term uptrend but are in a downtrend as defined by lower highs and lower lows. This means overbought is normally a sale until the downtrend changes.

A Drag on the S&P 500 ...

Source: Baseline

---

... and the Nasdaq

Source: Baseline

---

... and the Dow

Source: Baseline

Does that mean we have to tank and retest the lows? Not in an event-driven climactic bottoming process. My best guess is that the market should work off the overbought condition and enter a trading range where the focus should be on sector rotation rather than market bets.

As one sector corrects, money should flow into another, rather than into cash, because there is already too much cash on the sidelines and very few investment alternatives. As I said last week, the relative valuation of the consumer staple, health care and energy sectors should cause money to flow there as the more aggressive areas, such as technology and telecommunications, consolidate gains.

If the indices can make a higher high, then a longer-term trend change will be more evident. So far the gains are simply a significant bounce off a climactic low.

>To order reprints of this article, click here: Reprints