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Overextended Market Driving Higher

By: Sam Collins
Posted: 1/18/2011 4:16:00 AM
Referenced Stocks: CPI;JPM

Despite concerns that China was again going to tighten lending conditions, on Friday, financial stocks led the U.S. market to the highest level in two and a half years. It was the seventh consecutive weekly gain for the Dow Jones Industrial Average. The strongest groups were financials, energy and technology.

With the banks leading the financial group, JPMorgan Chase & Co. (NYSE: JPM ) rose 1% following a Q4 earnings gain that exceeded analysts' expectations. Bank of America (NYSE: BAC) rose 3.3%, and PNC Financial Services (NYSE: PNC ) was up 5.1%. And regional banks rose as well, with BB&T Corporation (NYSE: BBT ) gaining 3.39% and its rival SunTrust Banks (NYSE: STI ) rising 2.01%. Sterling Bancshares (NASDAQ: SBIB ) rose 2.9% after saying that it was a candidate for a buyout.

The PHLX Semiconductor Index (NASDAQ: SOX ) leapt 2.7% to a three-year high following an earnings report by Intel (NASDAQ: INTC ). The company exceeded earnings estimates, but the stock fell 1% after comments by analysts that it would have a tough time in the future due to a downturn in computer sales. Intel rose earlier in the week in anticipation of higher earnings, so despite the decline on Friday, it netted a gain of 2% for the week.

Economic news on Friday was mixed. The consumer price index (CPI) for December rose 0.5% versus an estimate of 0.4%. But the preliminary consumer sentiment survey by the University of Michigan for January came in at 72.7, below the anticipated 75.5. Retail sales for December increased 0.6%, which was also lower than expected. U.S. business inventories had a smaller-than-expected rise, and industrial production was up 0.8% versus an estimated 0.4%.

Treasurys lost ground on Friday. The 10-year note's yield rose to 3.334%, and the 30-year bond closed at 4.524%. The euro was slightly higher at $1.3375, up from $1.3351 on Thursday.

At Friday's close, the Dow rose 55 points to 11,787, the S&P 500 gained 9 points at 1,293, and the Nasdaq was up 20 points at 2,755. The NYSE traded 1.1 billion shares with advancers ahead by 1.4-to-1. The Nasdaq crossed 515 million shares and advancers were ahead by 1.8-to-1. For the week, the Dow rose 1%, the S&P 500 gained 1.7%, and the Nasdaq was up 1.9%.

Crude oil for delivery in February gained 14 cents to $91.54 a barrel. The Energy Select Sector SPDR (NYSE: XLE ) rose 75 cents to $70.65. Gold fell to a seven-week low with the February contract settling at $1,363, off $24. The PHLX Gold/Silver Sector Index (NASDAQ: XAU ) fell to 205.72, down $3.02. Support for the XAU rests at about 205.

What the Markets Are Saying

Despite sentiment and internal indicators that are overbought on a daily and weekly basis, the market continues to plough ahead. Mark Arbeter, chief technical analyst at S&P, appears confounded, saying, "The stock market continues to creep higher, as if propelled by some mysterious force that keeps the daily ranges very tight."

And Mark warns of a pending 38.2% or 61.8% Fibonacci retracement of the August lows, which, if the market reversed now, would take the S&P 500 down to 1,190, and then the 1,130 area.

Since the end of December, I've been cautioning our readers about the overbought condition of the market. At the same time, I've noted that as long as the trend is up, we should hold the stocks that we own. But recently, I've advised that a very cautious approach be considered for new positions. I believe that despite the statistical probabilities of a pending pullback, the timing of it is almost impossible to predict, so it's best to ride it out until a clear reversal occurs.

Those who have been in the market a long time know that markets have a mind of their own, and low-volume markets are especially susceptible to extended bull runs followed by very sharp corrections. The current run quickly vaulted the indices well above the initial targets that I set out in mid-December. You may remember that they were Dow 11,785, S&P 500 1,278, and Nasdaq 2,700 to 2,710. At that time, the Dow was at around 11,500.

To review, longer term I "guestimated" that before the end of the year, the following targets would likely be attained: Dow 12,800, S&P 500 1,400, and Nasdaq 3,700.

Here is how the numbers work: For the Dow, the top of April/May was the close at 11,205 minus the July low 9,686 = 1,519 + 11,261 breakout on Nov. 4 = 12,780 rounded to 12,800. That number also matches the resistance zone highs of January to July 2008. The same approach was used for the S&P 500.

But the Nasdaq is different. That index is much more prone to great over-runs that result in huge price/earnings multiples. Consider the dot-com bubble, which ran the S&P to an average p/e of over 120 times earnings and vaulted the Nasdaq to 5,048.62. Many tech stocks having never reported profits sold in the $50s and big-name stocks like Cisco Systems (NASDAQ: CSCO ), Qualcomm (NASDAQ: QCOM ) and Oracle (NASDAQ: ORCL ) shot to 200 times earnings. The top was made on March 10, 2000, when the index sold for more than twice its value of 12 months before. But a year later, it was down to just 40% of the peak.

Could it happen again? In my opinion, it's highly unlikely that stocks will become so overbought in my lifetime. But it won't be long before many investors will have no memory of such chaos, having been too young to remember. And even those who did live through it may blot out painful moments as the excitement of quick profits overwhelms the markets.

Tomorrow I'll cover why I think that Nasdaq has a strong possibility of reaching 3,700 in 2011.

For one tech to sell now, see the Trade of the Day .

Today's Trading Landscape

To see a list of the companies reporting earnings today, click here .

For a list of this week's economic reports due out, click here .

If you have questions or comments for Sam Collins, please e-mail him at .