April 4, 2011

This Month's Forecast: Not Your 'Average' April

Support levels need to be watched as high commodity prices and other factors come into play

April is the best performing month of the year for the Dow Jones. April also hosts the first-quarter earnings announcements, which will kick off with Alcoa on April 11.

Aside from good seasonality, April also offer some potholes, earnings might be one of them.

Many corporations have been cost-cutting their way to impressive profits. Multi-national corporations have benefited from a weak dollar and strong exports. But regardless of how they got to higher profits, it has raised the benchmark and investor’s expectations.

When it comes to profits, the past may come to haunt the present and the future. Why?

If you under-promise it’s easy to over-deliver. This principle applies to the quarterly earnings ritual. Coming from the depressed 2009 lows, there was a lot of room to grow. Corporate cost cutting and firing led to quick double-digit growth.

Following several quarters of higher than expected earnings, the profit margin for the S&P 500 is at about 8.2%. According to Standard & Poor’s, the profit margin over the past 15 years has averaged about 6.1%.

Based on Federal Reserve data, corporate profits as a percentage of national income were 12.7%. The average since 1951 is about 10.5%.

A broader measure of valuation looks at domestic stock market capitalization as a percentage of gross domestic product (GDP). In March 2009, this number was about 55%; today it’s about 95%, close to the level where a mean reversion tends to take place.

Mean reversions are mean in the sense that they don’t announce their appearance. Mean reversions take place when least expected.

It can take longer than expected for the mean to revert, but it’s safe to say it will ultimately happen. In 2007 nobody saw the mean reversion (stock market crash). In early 2009 analysts were busy lowering their earnings forecasts just as stocks put in a significant low.

Based on the investment community’s collective bearishness in early 2009, the ETF Profit Strategy Newsletter issued a strong buy signal on March 2009. Within the next three months, the major indexes ETFs like the SPDR S&P 500 (SPY) and Dow Diamonds (DIA) gained around 45% and kept going.

Two years later, stocks have arrived at the opposite side of the spectrum.

Currently, the down-side risk is exponentially larger than it was two years ago. In fact, the 2011 earnings season could be a rhyme to the 2010 earnings season.

"Buy the rumor, sell the news" has accompanied the April 2010 earnings season.

On April 16, 2010, the ETF Profit Strategy Newsletter noted that “at current earnings stocks are not cheap. The pieces are in place for a major decline.” Starting on April 26, the S&P tumbled 17%. This may not quite qualify a “major” decline, but it was enough to scare investors.

Based on historical data, stocks tend to perform well leading up to April 15. In fact, over the past few decades, April has been the Dow's best month of the year. Technical Analysis confirms the bullish early-April bias as long as the major indexes can remain above support.

Support levels need to be watched because this is not your "average April."

Rising commodity prices have crimped consumer spending and oil pricesare at the second highest level they have ever been in April. April 2008 saw the highest April prices ever and this didn't bode well for stocks for the remainder of the year.

Thus far the U.S. stock market has dodged a knock out punch from the 1-2-3 European debt crisis, Middle East conflict and Japan disaster combo.

Watching how the market behaves around support levels allows you to manage the downside risk. Important support levels outlined by the ETF Profit Strategy Newsletter recently included S&P 1,312, 1,270, 1,255 and 1,229.

A break below 1,312 would indicate that the correction from the February 18 high at S&P 1,343 would turn into more than just a few days of selling. A break below 1,270 would point towards 1,255 and 1,229. The brief dip below 1,255 (1,249 intraday low) triggered a bullish low-risk entry.

What's the significance of 1,229?

On February 18, the ETF Profit Strategy Newsletter cautioned: "If stocks don't fall below 1,229, we expect new recovery highs."

Resistance levels, the helpful cousin of support levels, allow you to outline the market's upside potential. Stocks stalling around resistance is often as troublesome as stocks dropping below support.

The most recent ETF Profit Strategy Newsletterprovides a trading/investing strategy for the month of April along with important support and resistance levels. As any other system, this doesn't guarantee success but it gives you the confidence to make decisions knowing that the odds are in your favor.

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