The Pause

About two weeks ago, I wrote a blog entitled "The Bottom Is For Real, But a Pause is Due." My reason for that blog and this one is to help my readers understand the push and shove of markets.

You may wonder why a number of my recent blogs have discussed elements of technical analysis, such as moving averages, levels of support and resistance, etc. Chart reading coming from a guy whose motto is, "so goes the dividend, so goes the stock," would seem to be a contradiction in terms. Technical analysis is for traders, isn't it. Technicians are people who couldn't care a twit about the fundamentals of a company or the products they make.

The truth is I grew up reading charts. I managed money in my early years using almost exclusively charts combined with a bit of macro-economics. That all changed in the crash of Black Monday in 1987. Something in me gave way that day. Something said that I should be buying, even though all my charts were saying to sell.

Since that day, I have become predominantly a fundamental investor. After searching for a number of years for a fundamental metric that best predicted stock prices, by the early 1990s, I was convinced that the metric I was in search of was dividend growth.

Having said that, at Donaldson Capital Management, we use any indicators we can find that work. Thus in our firm at present, we use three markers or predictors to determine what to buy and sell: 1.) dividends to select individual stocks and determine market valuations; and, 2.) macroeconomics to grasp the lay of the economic landscape; and, 3.) technical analysis to validate the first two predictors, as well as to provide clues about the economic landscape that the fundamentals do not explain.

Here is what our assorted markers are saying about the current situation.

1.) Using data from our Dividend Valuation Models, we believe that stocks are at least 25% undervalued based on the long-term relationship of prices, dividends, and interest rates. Thus, from a valuation perspective, the path of least resistance for stocks is up.

2.) Our macroeconomic view is that things are "less bad" than they were just a few months ago. A number of economic data points such as the sales of existing homes are trying to bottom but few, if any, economic data are showing genuine growth. This suggests that there is little fuel in sight to push stocks significantly higher. This would argue for stocks to pause at this level.

3.) This is where technical analysis comes in very handy. The chart above shows that in recent months stocks have made a solid turn, pierced the 50 day moving average, and are now trying to move through the 200 day moving average. Our experience in technical analysis tells us that a move through the 200 day moving average without a fundamental catalyst will be difficult. Thus, technically speaking, stocks are a bit overbought and in need of some consolidation, or sideways motion. This sideways trading is likely to be of a sawtooth pattern because the economic news is "less bad" and not yet good.

We believe that increases in corporate earnings expectations will ultimately be the catalyst that will push stocks through their 200 day moving average. Earnings have fallen like a stone for the past two years. But corporations have been slashing costs and earnings expectations for the S&P 500 recently ticked higher for the first time in a long time.

Cobbling together the three markers, we believe argues that stocks are likely to trade in a sideways range for at least another month or so. Coincidentally that is about the amount of time until the next earnings season. If corporate earnings come in better than expected for the second quarter, we believe stocks will pierce the 200 day moving average and push to higher levels. If earnings fail to surprise to the upside, stocks will likely continue to trade between 8000 and 9000 on the Dow Jones 30, awaiting better economic and earnings news.

We do believe that the March 9th bottom in stocks will hold under almost any circumstances. In March, stocks were pricing in the worst case scenario. The stabilization of the banks and the better news coming from the real estate market argue that the worst is over. We are now awaiting some of the green shoots that Fed Chairman, Ben Bernanke, described to blossom.