Dateline: 4/14/99

The front page of Saturday's FP Investing section of the National Post featured a small article tucked away in the lower right hand corner with the headline Crumbling market breadth signals correction: analysts. The article goes on to report that the breadth of the U.S. market "is starting to smell so bad it has a number of analysts holding their noses and bracing for a correction".

Bad pun aside, the article points out some sobering facts - market breadth (number of advancers to decliners) has been deteriorating since January and only a few large cap stocks are accounting for the surge in the major stock indexes. Less than 5% of of the firms on the S & P 500 account for its 9.7% increase since the New Year. "The market's narrowness is more pronounced now than it was just prior to last summer's steep correction," notes Nesbitt Burns chief economist Sherry Cooper.

Yet on page 3 of the same section, Sonia Horvitch's Buy & Sell column sports the headline Look forward to continued strength. The article cites Peter Gibson, head of quantitaive research at Scotia Capital Markets: "The major U.S. indexes will continue to be propelled by a handful of companies that persistently record outstanding profit growth". He expects good strength over the next twelve months.

Gibson believes that investors who focus on stocks exhibiting profit growth and momentum will achieve above average returns. Although he says that in the short term there are risks.

The headlines seem to indicate contrary positions, but both acknowledge that a few companies are moving the market indexes. They reflect the split personality of the current market. The difference is in how they see the outcome.

This inconclusiveness is reflected in two newletters I subscribe to. One, the Cabot Market Letter, has been advocating caution for some time now. The authors, Carlton and Timothy Lutz use a variety of momentum indicators in their analysis. They analyse individual stocks on the basis of company fundamentals and relative performance. They analyse the market as a whole by looking at advance-decline lines and the number of new lows charted each day as well as charting moving averages and interest rates.

Their Two Second Indicator, so-called because it only takes two seconds to check the newspaper and see how many new lows there are on the NYSE each day, must chart fewer than 40 four days in a row to be considered positive. This indicator has been negative since mid-January. Their X-Ray Indicator, which charts the NASDAQ A-D line against the 40 day and 70 day moving averages, has been negative since Feb. 4 when the A-D line crossed below the lower of the two moving averages.

They also use two other indicators, their Power Index, which charts interest rates, and their Trend Lines which measures the Dow Industrials and the Dow Transports against their respective moving averages. The trend lines have remained positive throughout this year, but the Power Index went negative Feb. 26.

The upshot of this is that the Lutzes are around 50% in cash and are holding on to only a few particularly strong stocks, all of which, incidentally, have continued to rise. But they cite historical precedent to show that the weak market signals indicate a possible, perhaps even probable correction ahead.

The other newsletter is Pat McKeough's excellent The Successful Investor. I subscribed to this one because of Pat's excellent reputation and track record in picking winning stocks. His outlook on the market is quite different. He believes we are in what he calls a two tier market. Certain segments have been driving the market, gaining new highs, while other segments have either gone down or drifted along in neutral territory. It has been primarily large caps that have prospered and small caps that have languished.

He compares today's market to that of the early seventies when the so-called nifty fifty traded at high P/E ratios and soared while the broad market did nothing. Then the entire market collapsed in 1973/1974. Today the two tiers are even more widely separated. The S&P 500 gained 26.7% last year while the average in the index gained only 10.8% (the difference due to how the stocks in the index are weighted). This is the highest discrepancy in 41 years.

But while pessimists say this phenomenon portends a bear market, McKeough doesn't agree. The differences between the seventies and the nineties are too diverse to compare the two. See the chart below for a comparison.

McKeough is strongly bullish on the market. You just have to pick the stocks that are moving ahead. He uses a combination of value, momentum, growth and quantitative analysis in selecting stocks and in the current issue (arrived in the mail Tuesday), points out the pitfalls of relying on any one method.

So there definitely is a split personality to the market. The question is, where will it go from here? The Lutzes and analysts like Sherry Cooper think the lack of breadth to the market indicates trouble ahead. A severe correction will drag down everything, so have cash on the sidelines and be cautious.

Post columnist Jonathon Cheveau shares this view in an article on April 3rd. "70% of all U.S. stocks have been in a bear market since last April," he quotes Mitch Harris of The Reality Check newsletter. He also quotes Ralph Burgess of Peer Financial who says anyone who doesn't take profits before the fall of 1999 will end up with serious problem. What will precipitate such a disasterous downturn? Chevreau doesn't say, but refers the reader to Burgess's pamphlet Y2K Investing: Pitfalls & Opportunities.

On the other hand, optimists like Gibson and McKeough argue that careful stock selection will mitigate any problems from a temporary downturn. They are long-term bullish. In fact, in his current letter, McKeough has an article arguing that Y2K will have a positive effect on the market. (See my Pundit Report for details.)

What do I think? My optimistic side wants to go with McKeough. My prudent side has me 50% in cash.

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