How Much Longer Can The Market Stay On Trend?

The S&P 500 has remained above its 55-day moving average for 124 consecutive trading days.  One hundred 20-four.  The events in Libya and the surge in oil prices have put investors on edge and the market now finds itself uncomfortably close to that support level.  Nobody seems to want to get in front of this low volume market meltup.  And that is the really curious part.  If the trend is your friend why has participation been so unbelievably low?

Our view of this rally is really about who is on the sidelines.  Most investors, including the institutional investors, are content to hold stocks and ride the rally as far as it will take them.  That would explain the lack of volume.  However, anytime there is a little fear thrown in, such as the action in Libya last week and Bernanke’s oil price comments this week, volume surges as the market slides.

Short covering has also played a pivotal role in the market’s rise since August.  Shorts have been absolutely steamrolled by the inability to force a change in trend.  Short interest was just shy of 14.5 billion shares in early September 2010.  The latest data from mid-February 2011 shows only 12.5 billion shares – the lowest level in years.

With investor volume waiting on the sidelines and shorts getting out of the market’s way it is little wonder the market has stayed on trend for so long.  The question is how long does this continue?

Markets that move in one direction without pause are always in danger of a rapid change in trend, even if it is only a correction.  In this market, should stocks break below that 55-day moving average and then close there, it might signal a breakdown in the current mechanics.  That might invite short interest to begin rising and, coupled with continued turmoil, convince sidelined investors that the ride is over.

For today’s markets, drowning in excess liquidity and interventions, a reversal can also be a product of the liquidity withdrawal process. We saw this already in 2010 — the market swoon from late-April through August came after the Fed had stopped printing money on March 31, 2010. Addicted to the easy credit, the markets and the economy began to reverse.

For 2011, the Fed’s current monetary stimulation is slated to end on June 30. If inflationary pressures combine with enough political pressure then quantitative easing may not be renewed. At that point volatility might sufficiently return to entice the institutional investors into shorting stocks again. Once marginal liquidity production falls off, like taking the addicted patient off pain medication, the pain of the uncured disease becomes very real again.

There is no shortage of market moving turmoil but until the trend is broken convincingly the current move will likely stay intact.  On the few occasions that stocks have challenged that 55-day moving average (and even the 20-day moving average) the bounce up comes quickly and, for the bulls, timely.

While we do not use technical analysis regularly for our investment strategies, in this case there is no denying the psychology.  As long as investors, potential shorts, international institutions, etc., believe liquidity created by the Fed will continue to reinforce the trend, they will be hard pressed to move in front of that monetary steamroller.  But if that trend breaks under the weight of the malinvestment that liquidity is forced to create (either inflation or economic strain), the reversal might be more powerful than most expect.

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