I must admit that the current strength in the stock markets caught me a bit by surprise; but now the charts are looking much better and bullish.

The overall market is moving higher. About 84.13% of all U.S.-listed stocks are above their respective 20-day moving average (MA), versus 64.95% a week earlier and 20.09% a month ago.

The key stock indices have nearly recovered the decline from the multi-year highs. After a dreadful May, the second half is looking good so far.

A key chart development for driving the rally was the recent upward break by the key stock indices above their respective 50-day MAs. On the charts, we are seeing a bullish golden cross, with the 50-day MA trading above the 200-day MA.

At the mid-year, the key indices are edging higher and up between 6.52% for the S&P 500 and the market-leading 9.06% for the DOW as of the close of July 6.

Small-caps are strong with the Russell 2000 up 7.11% and only trailing the DOW. I favor small-cap stocks, which tend to outperform following a recession when the economy begins to grow. Case in point: after the recession ended in 2009, the small-cap Russell 200 advanced 25.28% in 2010, easily outpacing the 11.02% and 12.74% return of the DOW and S&P 500, respectively.

Investor sentiment has improved, with the NYSE and NASDAQ showing a bullish signal in eight of the last 11 sessions to July 6.

In my view, the bias has reversed to positive, but I continue to sense there is higher risk overseas in Europe and with the inflation issue in China.

The debt resolution inGreecewas the catalyst for the buying, but there continue to be issues, asPortugal’s debt was recently cut to junk by Moody’s Investor Services. And, despite the continued growth issues inEurope, the European Central Bank elected to raise its key lending rate by 25 basis points.

In China, the country is battling its highest inflation in about 34 months by increasing interest rates and tightening bank reserve ratios. It’s helping, but you have to be concerned about the impact on global growth if China stalls.

Domestically, don’t forget about the massive deficit and debt. 

At this juncture, the charts are pointing to additional upward moves. Don’t fight the momentum. Ride it to potentially more gains; but, at the same time, you also need to be careful and use put options as a defensive hedge, as there remains some downside risk.

One of the things happening in this market is that trading action is occurring as a slow deterioration, rather than an outright correction. You can see this in the technology sector in particular. This kind of market is really hard on sentiment, because investors can’t see an endgame. In a bull market, investors can quite easily get their head around a major correction in share prices, and even expect it as part of the long-term trend. In a bear market, however, there is no defined outlook—only uncertainty about where things are headed.

We are in a bear market for stocks, even though the market’s done incredibly well since last September and the low set in March 2009. Accordingly, successful stock picking is significantly more difficult. Bear market speculating is about individual stock selection obviously and it more so involves event-driven trading (on both sides of the market) for incremental gains. Longer-term investing is much less of a priority among investors, because the time horizon for seeing a potential gain on investment is much longer.

This is a difficult market environment, even for commodity investors. The marketplace is desperate for earnings results and corporate visibility to provide some direction in which to act. Precious metal producers have reported, and continue to report, good news, but these stocks are also in retreat, as spot prices aren’t going anywhere at this time. And the price of gold is only slightly off its recent high. This is another sign that we’re definitely in a bear market for stocks.

My outlook isn’t necessarily bearish for the next few years. The broader market is not expensively priced and we are going to get continued earnings growth. But my feeling is that we are in a long period of lackluster returns, reflecting a lackluster economy that needs much more time to correct itself. That’s the thing with financial market investing. You’re at the whim of a marketplace that, at the end of the day, reflects the business cycle.

With micro-cap stocks from China in the doldrums and precious metal shares trading off spot prices, from a sectoral perspective, the best area for speculative new positions in this market is in biotechnology. I do expect the gold investment theme to pay off down the road. It already has for earlier investors. And even if it does so just on the back of a weaker dollar, institutional investors are keeping some exposure to gold as a hedge against sovereign debt.

I’d feel a whole lot better about the stock market if the S&P 500 Index were above 1,300. A key indicator for the broader market remains the Dow Jones Transportation Average. This index has been trending lower and 5,000 is an important technical support level. Second-quarter numbers can’t come quickly enough.

Loyal readers of this column are aware of the fact I usually write about gold, rarely about silver. Yes, they are both precious metals, but that have two very different roles in society and the economy.

I’ve always looked at gold as a safe haven against inflation and eroding fiat paper, especially the U.S. dollar. Silver is a metal used in industry, everything from photographic film to jewelry. My point has always been (and it may be severe) that, if the U.S. dollar in no longer the world’s reserve currency, what will replace it? I can’t see central banks buying silver as their reserve currency. We know central banks have always bought or sold gold as they have adjusted their reserves.

Some of the stock advisories we publish have made excellent picks in the silver mining sector—we have some silver stocks that quickly doubled in price. But the boom in silver prices was bringing in too many speculators. The COMEX, where silver futures trade, quickly put that to an end, which I compliment them for.

One year ago, an investor or speculator would only need to put up $4,250 of margin to control a single futures contract of 5,000 of silver. Effective this morning, it will now take $16,200 to control that same contract. The COMEX has increased the amount of money which investors and speculators must put up to control one silver futures contract by 281% in less than a year (actually, most of that increase came in the past couple of months).

Hence, the “weak hands” (as I call them) are selling out their contracts. In the first three trading days of this week, we witnessed the biggest drop in silver prices since 1983. Silver is down 19% in price since the end of April.

I celebrate what the COMEX is doing by increasing the margin requirements for silver futures traders. Long-term this will be a positive for the silver market. We can only wish the banks and government showed the same restraint in 2005 instead of allowing speculators into the U.S. housing market with no real limit on their speculation.

Is the bull market in silver over? I don’t believe so. Given the continued economic expansion (or should I say explosion) in China, demand for silver is increasing yearly. Those who control the futures market for silver are simply tightening the rules, forcing speculators out—a move that we will be a huge benefit for silver prices in the long term.

Michael’s Personal Notes:

Two international notes this morning…

Spain, which has introduced several unexpected deficit-cutting measures, saw demand at its government five-year bond auction fall yesterday. The yield on these bonds jumped to 4.6%.

Portugal reported earlier today that it expects its GDP to contract two percent in 2011 and another two percent next year. The country will be announcing further austerity measures.

Other countries like Greece and Italy are on very shaky economic ground. Germany is the only economy in Europe undergoing any real type of recovery.

My point with all this? Europe is economically fragile and could lapse back into recession. This will place added pressure on an already weak euro.

The U.S. dollar…the euro…which is the worst of both evils and which currency will the oil producers eventually demand for their oil? Stay tuned.

Where the Market Stands; Where it’s Headed:

The chart of the Dow Jones Industrial Average has been similar to a straight line up since March of 2009. I’m not going to fight that trend or the Fed’s desire to create a sea of liquidity for the economy.

Yes, upside is limited. But I continue to believe that we are still in a bear market rally.

What He Said:

“I personally expect the next couple of years to be terrible for U.S. housing sales, foreclosures and the construction market. These events will dampen the U.S economic picture significantly in the months ahead, leading to the recession I am predicting for the U.S. economy later this year.” Michael Lombardi in PROFIT CONFIDENTIAL, August 23, 2007. Michael was one of the first to predict a U.S. recession, long before Wall Street analysts and economists even thought it a possibility.

The first quarter is completed. For stocks, it was positive in spite of several bouts of volatility. The small-cap Russell 2000 finished the quarter tops, advancing over seven percent. Technology has also been showing some attraction in the recent weeks.

Now, as we move into the second quarter, the month of April has been the best performing month for the DOW, averaging two percent since 1950, according to the Stock Trader’s Almanac. A major reason for the buying in April is the positive anticipation of first-quarter earnings.

And whether it is penny stocks, micro-cap stocks, or S&P 500 companies, you have to be impressed by the sustainability of the positive sentiment. The real test now comes as stocks edge higher. We need to see a strong break higher or we risk a relapse.

The major stock indices have closed higher in eight of the last 10 sessions to Wednesday, but there is a red flag, as the associated trading volume continues to be light, which fails to help confirm a strong buy signal. Unless we see increased volume on the up days, you have to question the lack of mass market participation in the current rally.

The near-term signals have a positive bias, but you need to watch the overbought condition.

The sentiment in the market is bullish, as stocks continue on a nice two-year rally from the March-2009 low. The trend of the NYSE new-high/new-low (NHNL) has been edging higher, with 172 of the last 182 sessions bullish as of March 30. In the technology area, 128 of the last 140 sessions have been bullish. All the signs point to additional gains ahead.

As of March 30, about 81.33% of all U.S. stocks are above the 200-day moving average (MA), down slightly from 82.38% a month ago. For the shorter-term MAs, the monthly decline has been more significant. For instance, about 59.87% of U.S. stocks are above their 50-day MA, down from 69.76% a month ago. We could be seeing a pending market decline.

So, while the momentum points to additional gains, I feel somewhat nervous that there hasn’t yet been a correction of any significant magnitude, albeit there have been several down days of over one percent over the recent month. This is not to say stocks are overvalued, but I feel they are fairly valued based on the current economic and earnings metrics.

And, unless there are fresh data that support additional gains, stocks could trade sideways in a tight channel in the upcoming months.

With the two-year bull market, investors and traders are looking for a reason to sell and take some profits. At the same time, there is also a feeling of not wanting to miss out on more potential upside opportunities. Option traders could use call options to play potential gains, while taking some profits on current stock positions. In this way, you can manage the risk.

I also believe in adopting strong risk management to protect your investments and hard-earned capital. Take some profits and use put options to hedge against a downside move.

Today marks the ninth consecutive day of protests in Libya. It’s big news for American companies, because the rebellion in Libya is the first civil unrest in a major oil-producing country.

I’ve been following Libyan leader Muammar al-Qaddafi for years. If you thought Saddam Hussein was a piece of work, you need to do a Google on Qaddafi. He’s been milking Libya’s coffers for years. And now he’s telling us that, after 42 years of ruling the country, he will fight with every “last drop of blood.”

Back on February 4, 2011, my lead story for PROFIT CONFIDENTIAL had the headline, “Oil Stocks: Why $100.00-a-Barrel Oil Is a Reality.” Back then, crude was selling for about $90.00 a barrel. This morning, crude is trading at a 28-month high. No, I didn’t predict the civil unrest in Libya. My analysis of the price charts of crude oil and the stocks of major U.S. oil companies simply told me that the price for oil was headed higher, which I attributed to continuing demand in China (that opinion has not changed).

According to the International Energy Agency, Libya is the world’s 12th largest oil exporter, producing about 1.6 million barrels of crude a day, which is equal to two percent of global oil demand. So, the short answer is that there is little risk to your stocks if the oil taps are turned off in Libya. In fact, getting people like Qaddafi out of power is a long-term positive for American companies and your stocks.

But here is the real risk: If civil unrests in the Middle East spread to Saudi Arabia, it’s a different ball game altogether. Saudi Arabia is the world’s largest net oil exporter. It has one-fifth of the world’s proven oil reserves. While the government in Saudi Arabia has been less harsh and more generous to its citizens than Egypt and Libya, any civil unrest in Saudi Arabia will send oil prices skyrocketing and stock prices sharply lower in North America, as the oil crisis of the 1970s is played out again.

Rising oil prices lead to rising precious metal prices. I’ve been begging my PROFIT CONFIDENTIAL family of readers to own the precious metals, especially gold, since 2002. And it’s still not too late today! We are only in phase two of the bull markets in resource and precious metal prices. Phase three could make the NASDAQ run-up to 5,000 in 1999 look amateurish!

Michael’s Personal Notes:

Sure, all eyes are on Libya this morning. But we should look at what’s happening in our own backyard.

Mexico’s GDP was just reported as growing 5.5% in 2010—its fastest growth rate in a decade. Mexico is Latin America’s second biggest economy after Brazil. And Mexico’s economy is expected to grow between 4.5% and 5.5% in 2011.

Our neighbor economy is growing at a rate that is equal to 50% the growth of China’s economy; truly remarkable. Unfortunately, with that type of growth, inflationary pressures will increase substantially this year in Mexico, pushing the country’s interest rates higher.

To the north, Canada has been raising interest rates. To the south, Mexico’s interest rates are about to rise. And, in the middle, we have the mammoth U.S., where short-term interest rates remain near zero. Interest rates throughout the world are rising, but not in the U.S., as the American game of keeping interest rates low so the greenback continues its “quiet devaluation” among other world currencies continues.

The worst-kept secret in the financial world is the quiet devaluation of the greenback. How long will the game continue? Not long, my dear reader, not long at all. Paying back an ever-increasing national debt with cheaper U.S. dollars is starting to run thin with the foreigners who finance us.

Where the Market Stands; Where it’s Headed:

Yesterday, the stock market took it on the chin, with the S&P 500 having its single biggest daily drop since August of 2010. So, the question is: can one day of trading establish a new trend? Of course not! It will take much more than one down day to break the back of the strongest bear market rally I’ve ever seen.

Tuesday’s stock market action can almost entirely be related to the jump in oil prices. The higher oil prices go, the less money the big American industrial companies make, as their delivery and energy costs rise sharply. But, in this case, the unrest in Libya is placing pressure on the stock prices of the actual companies that produce oil, as their supply risk increases. The Dow Jones U.S Oil and Gas Index was the biggest loser yesterday, down 5.3% for the day, and that’s what brought stock prices lower

The Dow Jones Industrial Average opens this morning up 5.5% for 2011. The bear market rally in stocks that started in March of 2009 is alive and well.

What He Said:

“The Dow Jones Industrial Average, the S&P 500 and the other major stock market indices finished yesterday with the best two-day showing since 2002. I’m looking at the market rally of the past two days as a classic stock market bear trap. As the economy gets closer to contraction, 2008 will likely be a most challenging economic year for Americans.” Michael Lombardi in PROFIT CONFIDENTIAL, November 29, 2007. The Dow Jones Industrial peaked at 14,279 in October 2007. A “sucker’s” rally developed in November 2007, which Michael quickly classified as a bear trap for his readers. By mid-November 2008, the Dow Jones Industrial Average was at 8,726.

This is a bear market rally and the party is going to end soon. Sorry.

I’m not super bearish by any means, but rather realistic as to how far the stock market has come since the March 2009 low and even since last summer. In order for us to have a real bull market, we need a catalyst and I don’t see one as of yet. That catalyst has to be some major innovation or technological breakthrough (like doing business over the Internet) and it has to be sustainable.

Right now, the stock market is still playing catch-up. It’s still in recovery mode. U.S. equities are now trading on Chinese economic data. In fact, U.S. stock market sentiment is now based in part on Chinese monetary policy. Frankly, this isn’t good. It’s a sign that we’re still in a bear market, not a bull market.

The kind of catalyst that I’d like to see would be something like a major alternative energy breakthrough. The domestic economy needs global leadership again in some form of technological innovation that creates an entire new industry and, along with it, an entire new generation wealth. That’s what this economy needs in order to really fix the employment problem and that’s what the stock market needs in order to sustain a new bull market. Something like this, anyway.

Right now, stock prices are trading on hope and that’s hazardous. It’s hope for future economic growth, but there are so many structural problems in the economy (housing, employment, debt, deficits) that the current recovery seems to be solely due to the actions of the Fed, not individuals and entrepreneurs.

So, I continue to make the case that a stock market correction is imminent. Stock prices are stretched and the market can’t keep trading on China’s economic growth statistics.

We might not actually get a major selloff this year. The correction might take the form of a long-winded consolidation in share prices. We could get a long period of sideways mediocrity. Regardless, I think the winners will be those who own high-quality, high-dividend-paying stocks.

I’m very cautious on the stock market going forward. I like mining stocks the most for speculators and select Dow stocks for investors. I wouldn’t be a new buyer of equities at this time. The bear market rally is losing its steam.

The stock market still wants to go up, even though investors are wary of the recent run-up (because it’s lasted so long.) But there isn’t much else for institutional and individual investors to invest in. Bonds and money markets pay hardly anything and commodity prices look stretched. Aside from buying real estate, equities seem like the only game in town, which is why share prices are ticking higher on mediocre news.

Big companies always get the headlines during earnings season, but there are a lot of small- and mid-cap businesses that are reporting impressive growth for the fourth quarter. It always makes me feel better when earnings are growing across the board, and not just because big companies are squeezing expenses. Smaller companies continue to be the engine of the economy and, even though they get little coverage, what they say matters just as much as the big companies.

A lot of well-respected Wall Street veterans are musing about a big bull market developing in stocks—perhaps lasting into 2013. That is a real possibility if we don’t get sideswiped by big issues like sovereign debt, or war for that matter. Right now we have a very accommodative monetary policy, recovering growth in most mature economies, and robust growth in developing economies. It’s actually difficult to make the case that corporate earnings won’t keep growing over the next few years. And it doesn’t really matter if the housing market remains in the doldrums. That’s more of a consumer issue. The growth in earnings right now is at the industrial level.

I can certainly see a new bull market playing itself out, but it isn’t going to be without some major corrections. In my view, we’re likely to get one soon. Both in equities and in commodities.

Unless there was a major new shock to the system, I would go long if there was a major selloff in stock prices. Companies are running lean operations and, with price inflation starting to wiggle its way into the economy, modest amounts of revenue growth will translate quickly into major growth in earnings. We don’t need a runaway economy. All corporations need is modest top-line growth and the earnings picture should be rosy for some time to come.

Pull up a long-term chart on the S&P 500 Index and you’ll see that ominous head and shoulders pattern jump right at you. But, if you break it down, we’ve had that similar pattern before and the market’s made out alright.

I’m predicting a stock market correction sometime between now and the middle of the year. That’s no big news. If we get a consolidation in shares prices instead and inflation stays moderate, then I think we have the makings of new bull market. It would pressure interest rates down the road, but stock prices would likely stay ahead of this certainty.

It’s increasingly likely that stock prices will keep their positive bias going into 2011. That is, if there isn’t a major shock to the system like a new war or sovereign debt default. At the end of the day, the earnings picture, along with accommodative monetary policy, is supportive of rising stock prices. Goldman Sachs just predicted a solid year for stocks next year and the firm favors technology, cyclicals and commodities. They forecast that gold prices will keep ticking higher, but the price rise will slow in 2012, as the Fed begins to raise interest rates.

I’m still worried about the sovereign debt issue in Europe. This kind of risk can linger for a long time and come out of nowhere to kill a bull market. Equity investors have been patient for a number of years now and we’re all looking for a new cycle to rally around. The stock market goes up in anticipation of the future, so don’t be surprised if the broader market rallies even in the face of weak employment and housing numbers.

Practically speaking, a great way for an investor to play a 2011 rising stock price scenario would be to just invest in the index and then trade individual stocks as the opportunities arise. While history shows that small-caps tend to perform best coming out of a recession, I’d have a tendency to stick with large, dividend-paying stocks if I was a new buyer. No matter what the stock market does over the coming quarters, investment risk remains high.

I usually don’t like the buy high and try to sell higher investment strategy, but I think investors can do this with resources. If the Federal Reserve is going to entertain more monetary stimulus, then the outlook for the dollar remains weak. Real assets like oil and gold should continue to move higher in the current environment and there’s no doubt they are attractive momentum plays. Naturally, any equity portfolio should already have some exposure to these commodities.

Last quarter, corporations said that they expected their businesses to get better in the fourth quarter and going into 2011. Many cyclical companies reported that they were actually able to increase their selling prices without affecting demand for their products. This is always a good sign.

One key sector to keep an eye on is in transportation. In fact, if you want to know where the broader market is going, all you have to do is follow the railroads. Right now, most of these stocks are hitting new 52-week highs and several are hitting new all-time record highs. I suppose, this is as good a signal as any.

The bulls are in control, but you have to wonder how long it will last. The DOW recorded its third straight session of triple-digit gains on Monday and, in the process, rallied above 10,500 on a broad market rally. More importantly, the S&P 500 also closed above its 200-day moving average (MA) after recently managing to hold above the critical 1,040 level, which was a key development.

With the gains, all of the four key indices are trading in positive territory on the year, quite a reversal from just recently when the Russell 2000 was in a technical bear market, but is now down only 10.74% from its 52-week high. All four of the key stock indices have rallied above the 50-day and 200-day MAs — a bullish sign. Now we will see if the gains are sustainable. The market will need to see continued strong earnings and economic news to hold and advance higher. I expect some profit-taking given the overbought condition and hesitant Relative Strength, and based on the recent trading pattern.

As far as investor sentiment is determined by the new-high/new-low ratio (NHNL). The trend of the NYSE NHNL had been edging higher, with 13 straight sessions bullish from June 10 to June 28, prior to a dip to neutral, but 12 of the last 13 sessions were bullish. The near-term trend is positive. In the technology area, investor sentiment on the NASDAQ has been edging lower, with only 13 bullish readings since May 6, but the last two sessions were bullish.

NASDAQ

The near-term technical picture is moderately bullish on above average Relative Strength (RS), so there could be additional upside moves in the near term.

The NASDAQ is eyeing 2,300 and is above its 50-day MA of 2,228 and its 200-day MA of 2,260. Be careful, as the 50-day MA remains below the 200-day MA, but it has been edging higher. Watch to see if the index can hold, as the downward channel appears to be in place. The index is overbought, so watch for some near-term selling pressure.

DOW

The near-term technical picture for the DOW is moderately bullish with above average RS, so there could be additional upside moves in the near term. The DOW is above both its 50-day MA of 10,181 and 200-day MA of 10,402. Be careful, as the 50-day MA is below its 200-day MA. The index is overbought. There is a bottom at around 9,800 on the chart.

S&P 500

In the broader market, the near-term technical signal for the S&P 500 is moderately bullish, with above average RS, so there could be additional upside moves in the near term. The S&P 500 held above the key 1,040 level, and it has rallied above its 50-day and 200-day MAs of 1,083 and 1,113, respectively. There is key support around 1,040 on the chart. Be careful, as the 50-day MA is below its 200-day MA. The index is overbought.

RUSSELL 2000

The near-term picture for the Russell 2000 is moderately bullish on above-average RS, so the index could see more upside moves. The index trades with the economy. The index is above its 200-day MA of 639 as well as its 50-day MA of 639. The index is overbought. Watch for key support at 600.

Yet it’s not clear sailing by any means. Be careful, as the price trends on the indices are down and, unless there is a steady upside move, the trend will remain intact with additional downside moves going forward.