The first part of a three-step correction or bear market begins when prices start to fall in the face of favorable fundamentals. This is known as the disbelief phase as investors can not believe that prices can fall in the face of very good news.
The second part of the process, known as the belief stage, occurs when the fundamentals deteriorate, driving stock prices even lower. The third and last phase, which is usually accompanied by a throw-in-the-towel mentality, is called the fear phase, when everything in the press becomes negative and there seems to be no end in sight to the carnage. During this last phase, the market will sometimes move to an extreme oversold level, discounting the worst possible scenario.
We believe the market has gone through these three phases and is ready to turn the corner and start to move higher.
When the market goes through the final stages of a bottoming process, the fundamental news will continue to be very negative, but the market, which has already discounted this bad news, will rise in the face of negative company announcements and poor economic news. This is about where we are right now as there have been numerous announcements on the negative side and yet the market has held its ground and is actually starting to act better. The first part of an advance is characterized exactly like the first part of a decline, with disbelief.
Now, instead of the market retreating on negative news, it is advancing. These market phases have been seen for as long as there have been markets and just reflect human nature.
The catalyst for the turn in the stock market is the Federal Reserve's change in monetary policy to accommodative from tightening. Historically, easier monetary policy is very bullish for the stock market, with the best performance seen after the second rate cut. With fed funds futures discounting another 50 basis point cut at the January 31st FOMC meeting, and further cuts discounted during the first half of 2001, the market should be in pretty good shape over the near to intermediate term.
Adding to the catalyst of further rate cuts is that there is fuel on the sidelines to propel a decent size advance. The mutual fund cash ratio has risen to 6.5%, or nearly a four-year high, from just 4% in March 2000. Money-market mutual-fund assets have also increased as investors and institutions have pulled funds out of the market during 2000's weakness, and these assets now stand at record levels.
To add to the cash already on the sidelines, money flows into 401(k)s, IRAs, profit-sharing plans, etc. is heaviest during the first part of the year, which is why, from a seasonal standpoint, gains come early in the year.
Market internals of late have favored the NYSE over the Nasdaq. New NYSE 52-week highs vs. new 52-week lows have risen to the highest level since late 1997 and early 1998. New NYSE highs as a percentage of NYSE issues traded have moved to their best level since late 1997, which subsequently led to a very strong advance.
While the Nasdaq still trails on an internal basis, there have been some positives. The Nasdaq recently went to a new price low while the number of new 52-week lows showed a sharp contraction. This positive divergence is frequently seen at market bottoms. Another positive for the Nasdaq is the improvement in up/down volume, which is essential for a new intermediate-term advance. The improved internal readings on the NYSE vs. the Nasdaq have occurred because the NYSE has not dropped as much as the Nasdaq and because money has rotated to safer areas in the market during the Nasdaq's bear market.
However, as recent history tells us, more market confidence in the severely beaten-down Nasdaq will bring investors back to those areas of the economy that are expected to exhibit the most growth in the future. Even though the Nasdaq's internals are trailing, the likelihood is high that the more volatile and deeply oversold Nasdaq will once again lead the next advance.
With the Fed in an accommodative mode, money on the sidelines, sentiment very bearish, and seasonals favorable, the market looks primed to start surprising on the upside. Arbeter is chief technical analyst for Standard & Poor's