We had quite a week in the markets last week with the DJIA breaking through its all time highest closing price on Tuesday and then continuing that trend the rest of the week with higher closes each day through the end of the week.  The previous high for the Dow was hit way back in October 2007, on the eve of the financial meltdown. The financial press had a field day with the news.  Business network CNBC even went so far as to schedule a special program on the Dow hitting a new all time high Tuesday night.  From the euphoria we are seeing you would think that happy days are here again.

The reality of this situation is very different, though.  In spite of this record run and the continued crowing about individual company stocks hitting all time high prices, not everyone thinks everything is coming up roses.  In fact, if you thought Congress was divided, you should talk to financial folks.  No one seems certain about whether the markets are going to continue to climb higher or if we are on the brink of another meltdown.  There are great arguments on both sides of this debate.  So let’s examine them and see where we think we are going.  As an aside, as much as I am writing this for your benefit, I am also writing this for mine as well, as I am just as curious about where we are going as the next person.

In the bull camp to start is, simply, the inexorable climb.  It’s almost a case of a self-fulfilling prophecy.  If investors expect stocks to increase in price, they will buy stocks which will, of course, drive up the price.  Adding fuel to this bullish fire is the fact that a large amount of cash is still sitting on the sidelines.  That is, many investors have still not jumped on the stock bandwagon, meaning there is plenty of money to continue to drive demand for stocks.  There are additional tailwinds to push the market higher, or so the bulls claim.  Chief among them is the low interest rates on bonds, artificially induced by the Federal Reserve.  The Fed has effectively set interest rates at zero, keeping interest rates low in order to spur investing.  With long-term interest rates at minute levels investors have to look elsewhere for income and the one place they are going is to stocks, especially stocks that pay dividends.  Further, the bulls point out, company earnings are expected to get better and, since a company’s value is predicated on its earnings, this should continue to lead to higher stock prices.  Many bulls point to key measures of value such as the price-to-earnings ratio to show that the stock market is not overvalued at the current level and arguing for there being plenty of room for stock prices to continue to increase.

However, the bear side of the ledger has some pretty compelling arguments as well.  To start, the bears point out that earnings are actually slowing down.  In fact, earnings have fallen for the two quarters and may fall again this quarter.  Add in higher payroll taxes – workers had been given a break in how much they paid into Social Security over the previous two years, but that ended this past December – and the sequestration – the $85 billion in budget cuts coming this year – and you have a recipe for a slowing economy, reduced consumer demand and possibly a recession.  Bears point to a leaked email from Wal-Mart that announced a steep drop in sales in February driven primarily by the payroll tax increase which disproportionately hit their clientele.  Further, the bears point out that while the market is making new highs, trading volume is pretty light relative to what we would expect (see the bull argument about “money on the sidelines”).  Lastly, the bears point out that the Federal Reserve can only do so much and will eventually have to stop artificially depressing interest rates.

So where do we come down on this debate?  I am firmly in the middle.  I subscribe to many of the bear arguments – the artificial inflation due to low interest rates, the slowdown in spending due to sequestration hurting rather than helping the economy among them.  But I also subscribe to many of the bull arguments, as well.  Stocks really are the only game in town at the moment and there really is a lot of money on the sidelines (we are included in that, as we currently have roughly 20% of client funds in cash).  So what tips the scales for us?  Well, at the moment, it’s this chart (courtesy of StockCharts.com):

As you know from some of our past writings, we are fans of a style of charting known as “point and figure” charting.  This style doesn’t track every single price change in a stock or index but looks for shifts in momentum.  When the chart is in a column of X’s, the momentum is bullish and when the chart is in a column of O’s, the momentum is bearish.  As you can see, this chart of the DJIA is in a column of X’s at the moment.  There is a method of estimating how far up (or down) a stock might move from the past movements.  Based on this chart, we could see the DJIA climbing to 14,750 or so before running out of steam.  However, one thing to keep in mind is that charting – in fact, any kind of technical analysis – is not infallible.  Trying to read charts does not guarantee success and it certainly is not a guarantee of what is to come, but it can tell you a little bit about the psychology of the markets at the moment.  The psychology of this market is a grudging bull apparently as it continues to eke out gains little by little in spite of the wall of worries.

Given this sentiment, we continue holding good stocks with solid fundamentals.  However, we are keeping some cash on hand as we anticipate more volatility this year.  We know the Fed will eventually take their foot off the gas and this could have a negative effect on stocks, at least in the short run.  Over the long term, we continue to be bullish on stocks in general.  We have also started to refocus the fixed income side of our accounts to prepare for the increase in interest rates that is inevitable, though we have not sold any of our bond funds just yet.  There is no real need to panic as we see more potential for either a mild recession at worst or, at best, a grudgingly slow continued recovery.  In either case, it will be some months before interest rates really start to tick back up.  Stay tuned as this wonderful drama continues to unfold!