MDM - Model switches to buy January 12, 2011

Published : January 12 2011 at 8:36 ET

The market environment has been one of the most unusual with central bank intervention by way of quantitative easing (QE1 then QE2). While this has enabled markets to continue to drift higher into the end of 2010 on low holiday volume, there has never been a sustained strong rally without a valid follow through day (FTD). Investor's Business Daily once violated this rule by switching to a buy signal, but that buy signal proved false.

I learned while working for Bill O'Neil that cash is often king, especially during unusual market environments. He spent time on the sidelines then would hit the markets hard when the window was clearly open. In other words, the market will always be there, there will always be new bull markets, and so in unusual environments such as the one we're in, it is sometimes best to stay neutral.

While cash can be king, judicious selection of individual stocks can yield profits even during challenging times. Thus, we have continued to recommend stocks in our Pocket Pivot Review and Follow The Stock sections. Were the market to listlessly drift higher, odds are that the strongest stocks would continue to outperform in such an environment.

Interestingly, and not surprisingly, since permanent open market operations (POMO/QE1) started in March 2009, the market did not sell off by much over the next 14 months. Only when QE1 came to an end in April 2010 did the market unravel in May 2010. Since QE2 has been alive and kicking, and the market's uptrend has been relentless, more or less, since the model's September 1, 2010 buy signal.

The model has switched from neutral to a buy, albeit a cautionary buy, without a follow through day due to the following reasons:

1) The action of leading stocks has been strong, recouping after a weak showing around mid-December.

2) The trend is up.

3) The third year of an election cycle strongly favors a bull market. Since 1951, there have been 15 such years. The Dow averaged over 17% during this third year vs. averaging between 4-6% in all other years.

4) Quantitative easing remains in force until June 2011 when it may be continued with QE3.

5) Corrections continue to be short-lived over the span of QE2. Since the model's buy signal on September 1, 2010, corrections have been even slighter than what we saw during QE1 which spanned from the model's March 12, 2009 buy signal to the end of April 2010.

6) QE1 was heavily back-loaded, so we are seeing the bullish effects of this non-stimulus now.

That said, we will keep a tight fail-safe at NASDAQ Composite 2661, or about 2% from current levels, which undercuts the gap on January 3, 2011. This fail-safe is not set in stone, but is an approximate guide given where things stand. We will update members to either confirm or readjust this level, should the NASDAQ Composite move closer to this level.

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