Prepared by Dohmen Capital Research Institute, Inc.
In the February issue of Bert Dohmen's Wellington Letter, published
on January 24, I wrote:
"For now, it's time to be ready for a pullback or correction in the
stock market. It should not go very deep. But it does not preclude
a couple of scary days to the downside...I believe that a pullback
of 5-8% in many of the important market indices is ahead. This
could produce a 20-30% decline in some of the overextended stocks.
It will be healthy and cleanse the system from excesses. It will
restore the proverbial "wall of worry" that a bull market always
has to climb. It will increase cash levels in mutual funds as they
become more cautious. And it will readjust values and get them back
to trend line levels."
Well, that was two days after the top. You can't get better than
that.
I thought the correction would go to the first week of May. I was wrong, because the real upmove in the broad market started on April 29. In our Weekly Hotline on May 2, I wrote: "It (NASDAQ Composite) had every excuse in the world early in the week to plunge through important support levels. But instead it retreated from the abyss and headed upward. Most impressive to me was the fact that in spite of very strong economic statistics, the market moved upward. When the market does not go down on news that normally is negative, but instead goes strongly upward, you know the bulls are in charge."
I continued:
"At this point we have many confirmations, and more, that a solid bottom of the correction is in place and that this market is going higher probably for the duration of the summer. Therefore, it's time to get fully invested without further ado. The budget accord in Washington...should have a positive affect on the stock market over the near term. It will give an excuse for the Federal Reserve not to raise interest rates in the next meeting on May 21.
What we're seeing in the stock market right now is a "melt-up"
rather than a "melt-down" which many of the bears had expected.
Conclusion: Stay fully invested in the market for the next several
months.
This chart of the Dow Industrials and the NASDAQ Composite shows
that the lift-off in the big cap stocks started even earlier than
I expected. The first part of the upmove in the Dow was not
followed at all by the broad market. In fact, as you can see, the
NASDAQ Composite went down as the Dow Industrials went up. This
suggested that we needed one more downleg going into the first week
of May to have a convincing bottom. But the bottom came a few days
earlier.
NASDAQ Composite Index And Dow Industrials
As you can see, the NASDAQ upmove resembles a "melt-up." In four
weeks, the NASDAQ Composite gained what it had lost in the prior 14
weeks. That's a sign of power.
The chart of the Dow Industrials shows two parallel lines, which is
a trading band. Notice that the Dow Industrials are now very close
to upper range of that band. This will represent resistance and
most probably necessitate a pullback or consolidation in the
market. Occasionally, the market goes right through the upper end
of its band, but that's rare. If it occurs, it would be a sign of
great power.
Dow Industrials
Here's a longer term of the NASDAQ Composite going back to the 1994
bottom. Note the trading band. The NASDAQ can advance another 5%,
but then it will run into resistance.
NASDAQ Composite
The chart of the Value Line (Geom) Index, also goes back to late 1994. Note the channel lines. It is now penetrating the upper end of the channel, which is a very powerful signal. If it can continue, it would be very constructive for the market. Remember, this is the most valuable index, much more representative of the average person's investment portfolio than the Dow. It has made a new record high, showing that the market upmove is broadening out.
Value Line (Geom) Index
Also note that the support level, indicated by the horizontal line,
held beautifully on the correction earlier this year. To explain,
a previous top usually serves as support when a market declines. It
certainly did this time.
The Dow Jones Utilities Index, which was so weak, has staged a very
nice recovery. The spurt upward in early May gave way to a normal
pullback. But now it is rising once again. This suggests that long-
term interest rates are going to decline. This is a very healthy
sign for the entire stock market.
The S&P Mid-Cap 400 Index has just reached the upper channel line,
which normally is resistance. But as we saw with the Value Line
Index, it could punch right through in a very powerful upmove. We
will watch it closely.
The big question for analysts is whether the small cap stocks are
finally catching up to the big caps and whether this is more than
just a short-term blip. Let's take a look. This chart is the S&P
500 Index versus the S&P small company stock index. When the chart
rises, the S&P 500 is stronger than the small caps. Note that since
the market rally started in late April, the small cap index has
outperformed the large company index.
S&P 500 Versus S&P Small Co. Index
It's too early to conclude that this is the start of a long-term trend. However, the MACD indicator has convincingly crossed over to give a "sell" signal. This suggests that an important trend reversal may be in progress and that small cap stocks will outperform the large cap on at least an intermediate-term basis.
The last time the MACD crossed over was in early 1996, which gave rise to a very strong five-month rally in the small cap stocks.
However, the uptrend line would have to be penetrated to signal a convincing trend change. And that would take some doing.
The Russell 2000 Index, which is representative of small company
stocks, and is thus widely watched, hit the lower part of the
trading channel during the recent correction. It started a powerful
upmove and is now on its way toward the upper channel. What's
interesting here is the MACD indicator. Because this is a long-term
chart (weekly) the signals have much more significance than on a
daily chart. Whenever the MACD has dipped below the zero line it
has given rise to a very powerful upmove. This suggests that the
current upmove is coming in from a base rather than the market
being in a topping phase.
Conclusion: Some of the most important indices are approaching the upper extent of their long-term trading range. This will present resistance. However, the Value Line Index has already broken out above that, which is a sign of a powerful market upmove.
What does it all mean? It suggests to me that while the big cap
stocks may go into a trading range or consolidation phase for a
while, the mid-cap and small-cap company stocks may continue
upward.
The International Equity Markets
The international markets look very bullish. Strongest are the
European markets, with some continuing their almost parabolic
upmoves. This signals that Europe is starting a mild economic
recovery and that there is a flood of money to scoop up the
bargains. European stocks are much cheaper than U.S. stocks on a
valuation basis, and some of the top companies in the world are
located there.
One of the strongest markets is Spain. The Madrid Exchange Index shows an almost doubling since September of last year.
The Zurich Market (Switzerland) has also been in a powerful upmove.
Some of the premier consumer goods and pharmaceutical companies are
located there. No inkling of a top there.
The Latin American markets are still hot. Mexico continues to stay
in its long-term up-channel. It recently made a new record high.
It's a long ways away from the upper part of the trading channel,
which suggests plenty of room to the upside.
On to Asia, we see signs of renewed life. The Japanese Yen had a strong rally, prompted by central bank intervention. This boosted the Japanese stock market, as it makes the market more attractive for foreigners on a currency translation basis. The Tokyo Nikkei Index shows the strong upmove from the 17,500 area to over 20,000. But now the index is in strong resistance. A pullback should occur soon, probably linked to a renewed weakening in the yen.
The Hong Kong Hang Seng Index has gone to a new record high in the latest upmove. It is now even trying to exceed the upper part of the trading channel which has been in place since the beginning of 1995. Next month is the great transition in Hong Kong. I have a feeling that we may be seeing an upside blowoff, which will be used by the smart insiders to unload their holdings. I would avoid that market from now on until the situation becomes clearer.
Conclusion: The international markets are soaring, which confirms
the strength we see in the U.S. The most attractive from my point
of view, especially on a risk versus reward basis, are the major
markets in Europe. Madrid seems to be the most powerful market over
there.
The Global Bond Markets
In the U.S., analysts are preoccupied with what the Fed will do in
its next meeting. Once the next meeting is over, they worry about
the following meeting. Well, it gives economists something to do.
In the meantime, let's look at the charts. The 30-year T-bond Yield
Index shown here (the scale on the right is the yield scale where
70.000 is 7%) shows that yields lately have been heading down
toward the 6.9% level. The uptrend line currently is at 6.8%. If
yields go below that, it would be a powerful signal that bond
prices will continue to rise.
30-Year T-bond Yield Index
Conversely, if the upper trend line which is heading downward were
penetrated, it would suggest that yields will go toward the 7.2%
area and possibly higher, as bonds decline.
Let's look at the MACD indicator. Note that the pattern recently at
"B" is very similar to what was seen in October of last year at
"A," which followed a plunge to much lower yields. If the MACD
crosses over again to the downside, it would suggest a very bullish
environment for bonds and stocks.
The chart of the Emerging Bond Market is still powerful. The index
just made a new record high. This is a very sensitive index and
suggests that there is no great danger of bond yields soaring
upward, i.e., bond prices plunging. This is still my favorite area
in the bond market.
One of the most important bond markets in Europe is the British
Gilt. The uptrend, which has been in place since 1994, is still
intact. The gilts recently made a new two-year high, which is
bullish.
Conclusion: The major bond markets suggest that the interest rate environment is benign, and that the long-term trend toward higher bond prices and lower yields is still intact. However, from a risk versus reward viewpoint, I much prefer the equity markets.
The "melt-up" in the market which I forecast in our Weekly Hotline on May 2 materialized and we now have most of the indices in record high ground. Some of the recoveries were absolutely astonishing. After such a powerful move, a brief period of consolidation is absolutely normal. I believe that's what the market will do over the next several weeks, especially in anticipation of the Federal Reserve Board meeting on July 1. After that meeting, the market can have another leg upward, no matter what the Fed decides.
Therefore, I suggest that any weakness in the market should be used
for buying my recommended funds rather than selling. In our last
issue, published in the middle of April, I was a little bit too
bearish based on the strong words coming out of the Federal
Reserve. The damage that had been done in the correction, and in
the overall stock market since May of 1996, was enormous. The
market became way oversold and the bargain hunters had an excellent
opportunity to deploy their cash.
The broad market upmove actually started at the end of April,
whereas the blue chips had started their rally two weeks earlier.
The power of the upmove, based on the number of advancing versus
declining issues, the sharp rise in the number of stocks making new
highs, and the move of the TRIN by May 2 all confirmed that it was
time to "get fully invested." That was my advice in that message.
If you have participated, congratulate yourself. I don't see any
major problems for the next several months, unless the Federal
Reserve for some strange reason decides to boost interest rates by
a much greater than expected amount. I consider the probability
very low.
On the other hand, the Fed could decide to leave things as they
are, which would be very bullish.
The strength of the markets around the world, especially in Europe
and Latin America, reconfirmed the worldwide bull markets. When all
these markets are rising in unison, it's very bullish. I suggest
remaining fully invested.
And the small cap and mid-cap stocks will outperform the big caps
this year.
June, 1997
Bert Dohmen
Dohmen Capital Research Institute, Inc.
A Division of Dohmen Capital Group
66 Queen Street, Suite 3801,
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