Is Cash King Or Should You Jump On The Rally Bandwagon?

• By Simon Maierhofer
• On 11:18 am EDT, Monday March 30, 2009

$10,000 invested in the S&P 500 (NYSE: SPY - News) exactly 10 years ago would be worth around $7,400 today. $10,000 invested in long-term Treasury bonds (NYSEArca: TLT - News) on the other hand would be worth in excess of $13,000. Cash has been king. Is cash turning into trash though?

Savvy investors who had moved their money out of the market are beginning to wonder if they've just missed the onset of a new bull market. The lack of conviction surrounding the future prospects of this rally is exactly what contrarian investors use as a signal to jump in.

Before we discuss the fate of this rally, let's recap the past 18 months as historic patterns will be the cornerstone for a reliable forecast.

The sky is the limit

Up until October 2007, there was no perceived limit to how high the stock market (and real estate market) would rise. The pre-conceived notion of ever-rising prices drove home-buyers to settle for interest only or ARM mortgages while mutual fund managers loaded up on stocks of all sorts. Days before the market's all-time high, mutual fund cash reserves had reached an all-time low.

What happened thereafter has become one of the darkest chapters of financial history. The biggest asset deflation in centuries affected domestic and international equities as much as commodities. Even bonds did not provide the expected protection. Investor's flight for safety has made the SPDR Gold Trust (NYSEArca: GLD - News) the second largest ETF in the country. Nevertheless, the price of gold has been confined to a tight trading range.

ETFs representing the above asset classes include the iShares Russell 1000 (NYSEArca: IWB - News), iShares MSCI EAFE (NYSEArca: EFA - News), PowerShares Commodity (NYSEArca: DBC - News) and iShares Aggregate Bond (NYSEArca: BND - News).

The last time investors felt confident about the market was in January 2009. In fact, the CBOE Put/Call Ratio (considered the 'fear index') recorded levels of confidence not seen since the stock market's all-time high. Extreme investor confidence, seen in October 2007 and January 2009, lead to waterfall declines.

The ETF Profit Strategy Newsletter (a subscription based service) observed the following already in December 2008: 'Optimistic sentiment, which should be visible above Dow 9,000, will give way to further declines.' The Dow closed above 9,000 from January 2nd to January 6th before losing 25% and more.

As you can see, there is a link between investor sentiment and the market's performance.

Just when you think it will get even worse

On March 9th, 2009, the Wall Street Journal featured the following article: 'Dow 5,000? There's a case for it.' Ironically, the Dow (Amex: DIA - News) and other indexes bottomed that day and rallied 20% or more since. By the definition of many common Wall Street guidelines, this 20% bounce technically reigned in a new bull market.

The government's recent plans to tackle the economic crisis are commonly credited for sparking this rally. MarketWatch reported on March 26th, 'faster than Geithner seemed to be going down with the financial ship, he now appears to be confidently leading us to shore. Geithner is the face of this week's market rally.'

In actuality, the market had started to rally two weeks before President Obama, Mr. Geithner or anyone else offered any significant suggestions. The market's rally is in full harmony with the January 15th ETF Profit Strategy outlook: 'The best target for a low is 6,700 for the Dow and 700 for the S&P 500. Extreme pessimistic sentiment may drive the indexes even towards Dow 6,000 and S&P 600. Once the new lows are reached, the markets should stage the biggest rally seen since October 2007.'

According to Birinyi Associates, this 20% rebound within 13 trading days was the fastest 20% rebound from a bear market low since 1938. Yet, bears are concerned that this rally will prove to be just another decoy rally like the one seen late last year.

The mere suspicion connected with the recent bounce means that this rally has further to go. The rally will likely exhaust itself once the general belief sets in that March 9th marked the end of this bear market.

Just in time for the biggest profits, ETF Profit Strategy subscribers received a Trend Change Alert notice on March 2nd outlining ETF profit strategies for conservative, moderate and aggressive investors.

Our recommendations ranged from plain vanilla ETFs such as the iShares Russell 3000 (NYSEArca: IWV - News), Nasdaq (Nasdaq: QQQQ - News) and Vanguard Consumer Discretionary ETF (NYSEArca: VCR - News) to aggressive plays such as the Ultra Financial ProShares (NYSEArca: UYG - News) and Ultra S&P 500 ProShares (NYSEArca: SSO - News).

As mentioned earlier, investors commonly believe that a 20% rise in the Dow or S&P signals a new bull market. More often than not, a new bull market tends to back up a 20% bounce. However, there are occasions where a 20% rally was followed by lower lows. From November 1929 to April 1930, the Dow Jones rallied 48%. This rally however was followed by an 85% drop from the April 1929 highs to the July 1932 lows.

An analysis of more than just investor sentiment is needed to determine whether this rally, however powerful it may be, will reign in a new bull market. An analysis of dividend yields and P/E ratios shows that major market bottoms always go hand in hand with dividend yields and P/E ratios reaching certain levels.

In fact, a study of those two indicators lets you pin-point a target range for the ultimate market bottom

.

The March issue of the ETF Profit Strategy Newsletter contains a detailed study of the four most powerful long-term gauges (including dividend yields and P/E ratios) along with specific target ranges for the end of this bear market.

Knowledge is the most important asset when it comes to protecting your wealth, however as Sudie Back put it, 'Be curious always! For knowledge will not acquire you; you must acquire it.'

Buzz up!