With February in the books, the stock rally over the first two months of the year and especially in January has been more substantial than I expected. I was thinking of 1,400 for the S&P 500 if everything worked out, but with 10 months left in the year, the index is a mere 28 points from 1,400 and at its highest levels since 2008. The blue-chips Dow Jones Industrial Average closed above 13,000 on Tuesday—the first time it has been done since 2008—and is within 1,160 points of its high of 14,164.53 on October 9, 2007.

Tech and small-cap stocks continue to lead the broader market similar to what we saw in 2010 when the NASDAQ and Russell 2000 surged 16.88% and 25.28%, respectively. The NASDAQ is already up 14.62% as of the close of Tuesday and will likely take a run at bettering its 2010 results. Small-caps have more room to advance to match the index’s performance of 2010.

With the upward stock rally in stocks, we are again beginning to see euphoric comments from the press talking about the stock rally moving towards the historical highs.

While the market sentiment continues to be bullish, with the new-high/new-low ratio displaying a bullish reading in each of the last 30 straight sessions dating back to January 17, I doubt the stock rally will continue to advance higher at the current rate.

After a blistering January, February has shown some stalling, with the stock rally facing more upper resistance on the charts. I expect this to continue.

A look at the technical picture shows an overextended rally that is technically overbought and vulnerable to profit-taking. The bias points to higher gains, but the lack of strong trading volume is indicating a red flag and the absence of underlying strength.

The bearish divergence between price and volume is important and indicates uneasiness in the stock rally. Take a look at the volume of the NASDAQ. In the first two months of this year, there were only three sessions with over two million shares traded, so this doesn’t reflect strong confidence in the stock rally and mass market participation.

Of course, some would also argue that if traders and investors came back into the market when the risk declines, there could be a massive drive for the stock rally. This is true, which really makes this current market difficult to play.

You don’t want to exit too early; but, at the same time, you also don’t want to be left with big losses if the stock rally fizzles out in a market correction.

The key is to take some profits along the way, but also make sure you have some put option hedges set in place in case stocks do reverse course.

If you want to know what stocks may be ready for a run, you want to monitor what the professional money is doing. You can read my take in Making the Best Investments: Should You Follow the Pro Money?

The Dow Jones Industrial Average has really done a good job of recovering from the subprime mortgage meltdown low set in March 2009. During the financial crisis, the Dow Jones was at a level not seen since the spring of 1997 and it took 10 years for the index to break 13,000. Since the March low in 2009, it’s taken the Dow Jones only three years to accomplish the same thing. Looking back, it was one of the best trades going if you had the guts to buy into the fear. Buying around the stock market low in early 2009, you would have doubled your money, while owning blue-chip companies that pay dividends. Hindsight is always a luxury.

The Dow Jones Transportation Average is diverging, but it’s done so before on lots of occasions. Oil prices have been trending higher since the beginning of February and the Transports, as a group, were due for a correction. I don’t want to see this divergence last much longer, as this would be quite a bearish signal for the broader stock market. With the upwardly revised fourth-quarter gross domestic product (GDP) number showing decent strength, I find it hard to imagine that railroad and trucking stocks won’t keep doing well.

The big-cap companies that make up the Dow Jones Industrial Average have only recently been usurped by the performance of the NASDAQ. Since the beginning of February, large-cap technology has beaten the Dow Jones and corporate earnings within the sector have been surprising. (See Fourth-quarter Earnings: Taking the Market’s Pulse.) This is a positive signal for the rest of the stock market. You can’t really have a bull market without participation from the technology sector.

There are two big questions now. Will this year’s early success from the stock market continue? Will it last throughout the year and going into 2013? I don’t know the answers to these questions, but I do know that there are enough data to support the bulls in the short term, and the bears later on. The stock market is due for a correction and it’s likely that we’ll get one. But, it is an election year and the Federal Reserve is on board (for better or for worse) to keep pumping money into the system. With unprecedented interest rate stability, I wouldn’t be surprised at all if the Dow Jones got back up to its all-time high of around 14,000.

There is no way to figure how the stock market will unfold in 2013. The structural problems in mature economies (mostly related to sovereign debt) are not being fixed—only sugarcoated. This decade will be an age of austerity, so economic growth rates should be lower than in recent history. From my perspective, all bets are off for the stock market going into 2013. I’m bullish on the Dow Jones this year and I like those dividends. The stock market is close to a correction and we’ll get one. For new investors, this will be a buying opportunity.

The Dow Theory, a reliable indicator of stock market and economic direction that has been around for almost 100 years, is flashing a warning signal.

The Dow Theory looks at the relationship between the Dow Jones Industrial Average and the Dow Jones Transportation Index.

The Dow Jones Industrial Average is an index made up of the stocks of 30 large American corporations. The average includes companies like Kraft Foods Inc. (NYSE/KFT), General Electric Company (NYSE/GE), Bank of America Corporation (NYSE/BAC), and IBM Corporation (NYSE/IBM).

The Dow Jones Transportation Index is an index of the largest transportation companies in the U.S. From railroads—Norfolk Southern Corporation (NYSE/NSC)—to airlines—Delta Air Lines, Inc. (NYSE/DAL)—to trucking—C.H. Robinson Worldwide, Inc. (NASDAQ/CHRW)—to marine transportation—Overseas Shipholding Group, Inc. (NYSE/OSG).

The Dow Theory states that the rise or fall in the Dow Jones Industrial Average must be confirmed by a rise or fall in the Dow Jones Transportation Index. This makes sense, because if the economy is growing, large corporations will do well and, in turn, ship more goods and services across the U.S. and around the globe, which means that the transportation companies will directly benefit and their stock prices will rise, too. The opposite also holds true.

The Dow Theory has been a very good tool over the last 100 years for calling market tops and bottoms.

Since 2009, the Dow Jones Industrial Average and the Dow Jones Transportation Index have been following each other closely. Something happened after February 3, 2012, however. The Dow Jones Industrials continued to climb higher, reaching a four-year high of 13,000 (which I predicted), while the Dow Jones Transportation Index has fallen three percent since then.

Recently, I introduced you, dear reader, to the Baltic Dry Index, which tracks the shipping rates for bulk commodities around the world. (See: Key Economic Indicator Hits a 25-year Low.). I can tell you that the rates have continued to fall over the last month. As a matter of fact, the rates being charged shipping bulk commodities now are the same rates charged in 1986!

The Baltic Dry Index indicates clearly that there is a demand issue here…more evidence of an economic slowdown. It is no wonder that the Dow Jones Transportation Index is falling.

Since this move in opposite directions three weeks ago between the Dow Jones Industrial Average and the Dow Jones Transportation Index, it is possible that the Dow Theory is signaling a top in the markets. (However, it is important to note that this trend has only been in place for three weeks.)

I will be following the Dow Theory for my readers closely over the next couple of weeks, as we may have another confirmation of the stock market top I’ve been alluding to in my recent writings. So watch out for that stock market rally; the warnings of the rally getting close to a top are building.

Michael’s Personal Notes:

It’s looking more and more as if 2012 will disappoint and be a year of economic slowdown, not growth.

The largest economies in Asia, India and China continue to exhibit signs their economic slowdown is accelerating. For February, China’s manufacturing index showed contraction for a fourth straight month.

My warning is that if the economic slowdown continues to take hold in Asia, there is no way the U.S. will not become a casualty.

India just reported its latest numbers for industrial production for December 2011. Industrial output climbed only 1.8% year-over-year, dropping off from the 5.9% advance year-over-year in November.

The Bank of India has signaled that the economic slowdown in manufacturing and the other indicators it follows means the bank is now changing its stance from increasing interest rates to lowering interest rates.

The Bank of India now believes gross domestic product (GDP) ill rise only 6.9% (if it reaches that) in 2012 after GDP expanded 8.4% in 2011. The 6.9% GDP growth for 2012, if achieved, would be the slowest rate of growth since 2009.

Japan’s economy shrank twice what was expected in the fourth quarter of 2011; whereas GDP actually fell 0.6%. Granted, Japan still is dealing with rebuilding from the horrible tsunami disaster of last spring, but those within the Bank of Japan acknowledge that the number was worse than expected because of fewer sales to Europe—economic slowdown.

There is a consistent theme with the weaker economic numbers above. All the countries I speak of above were negatively impacted by slowing export sales to Europe, which brought the economic slowdown home to their respective countries.

As the vicious circle of the economic slowdown continues to play itself out, Europe’s economic woes will worsen, which will affect Asia—especially China—and that in turn will bring the economic slowdown home to the U.S.

It is important to note that, as we move forward in 2012, to date, the economic statistics coming from Europe and Asia continue to worsen. This means that the economic slowdown is gaining momentum to the downside.

As a result, when the economic slowdown finally hits the U.S. (and the time is not too far off), the impact will be that much greater. Be careful with that stock market rally, dear reader, the economic slowdown is coming ashore. (Also see: How the Massive Global Economic Slowdown Will Affect Us.)

Where the Market Stands; Where it’s Headed:

Wow! What a run the stock market has had his year. The Dow Jones Industrial Average has gained 813 points in the first two months of 2012; that’s a gain of 6.7% in two months.

I believe that the bear market rally that started in March of 2009 has some leg left to it. Sure, the rally is getting old and tired, but I believe it has further room to move on the upside.

What He Said:

“I see the coming recession being deep and difficult, because U.S. consumers do not have the savings to spend their way out of the recession. The same thing happened in Japan. The Japan example proved that, when consumer confidence is shattered, even zero percent interest won’t spur consumer spending. The same thing could happen here.” Michael Lombardi in PROFIT CONFIDENTIAL, August 23, 2006. Michael started talking about and predicting the financial catastrophe we began experiencing in 2008 long before anyone else.

The Dow Jones Industrial Average blew past the psychologically important 12,000 level yesterday. What a feat!

Less than a month ago, on October 4, 2011, the Dow Jones Industrial Average was at its lowest level since September 2010: 10,400. The widely followed stock index has gained 1,800 points, or 17.3%, in less than a month.

I know that everywhere you look in the media today you will read and hear that the stock market took off yesterday because European leaders and European banks have agreed to a bailout to save Greece. But this is not the real story as to why the stock market ploughed through the 12,000 mark—only inexperienced market watchers can be crediting activities in Europe.

The real story here, the reason stocks have risen so sharply from the beginning of October, is that the stock market became so oversold. How quickly we forget. The stock market had a terrible summer. The Dow Jones Industrial Average collapsed more than 400 points on several days in August.

The stock market simply became severely oversold. When you have stock market advisors turning to their most bearish level since March, 2009, the Dow Jones Industrial Average will simply propel the other way. Never forget—in the majority of cases, the market does the opposite of what is expected of it. When the majority of investors and stock advisors are bullish, the market will go down. When the majority of market players are bearish, the market will rise.

Let’s face the facts. At a level of 10,400, the Dow Jones Industrial Average produced a dividend yield of three percent. Compared to a three-year U.S. T-bill yield of 0.52%, stocks were a bargain. And that’s exactly what I been yelling about since the summer (Stock Market & Gold: An Opportunity Like We’ve Never Seen Before?).

“So Michael, where do stocks go from here?”

I believe stocks will continue to rise in the immediate term. The Dow Jones Industrial Average has momentum to move higher. I believe word is spreading that stocks are a good alternative to other investments. As stock prices rise, more stock advisors will turn bullish. And this exactly what this secular bear market wants—more investors to get back into stocks.

I will do my best for my readers to signal the point at which I believe the stock market has ended its current Phase II—the rally that brings investors back into stocks big-time. We could be experiencing that final, big blow-off for stocks to the upside I have been writing about.

Michael’s Personal Notes:

Over the past few weeks, I’ve been writing in PROFIT CONFIDENTIAL quite consistently on how the stock market became oversold this summer and was due for a bounce. I’ve been writing that, against the backdrop of widespread investors and consumer pessimism, combined with better-than-expected corporate earnings, stocks would rise. This is exactly what has happened.

Corporate earnings for the S&P 500 companies in the third quarter of this year have risen by an average of 16%—better than analysts had expected.

But here’s something that’s more important:

A Bloomberg Consumer Comfort Index survey last week revealed that 95% of those surveyed had a negative opinion about the economy, the worst reading of consumer confidence for the index since March 2009.

There have been several measures of consumer confidence released as of a late that say consumer confidence is at its lowest level since the stock market hit a 12-year low in March of 2009.

Long-time readers of my column are quite aware of my contrarian attitude towards investing—the best profits are made going against the “herd mentality.” When you have stock market advisors at their most bearish level since March 2009 and consumer confidence also at its worst level since March of 2009, you have a catalyst for higher stock market prices.

What happened when consumer confidence hit a low in March 2009? Stock prices started to rise. In fact, the stock market went up almost 100% from March of 2009 to May 2, 2011. Since the Dow Jones Industrial Average hit 10,400 on October 4, 2011, the stock market has rallied 17%.

As I have been writing, the stock market will continue to ride the wall of worry higher, as stock advisor and consumer confidence pessimism remains at highs not seen in almost 30 months.

Where the Market Stands; Where it’s Headed:

I’ve been writing in this column about the Dow Jones Industrial Average getting back up over the 12,000 and that’s exactly what we got yesterday. In a “huge” move, the Dow Jones Industrial Average propelled yesterday to 12,208. The world’s most widely stock market index is up 5.6% for 2011, not including dividend payouts. This market is looking more and more like 2010’s all over again (Today’s Stock Market: Making Money by Copying Last Year’s Action).

It has long been my belief that we are in a bear market rally that started in March 2009. That rally will take stocks higher first, before the bear market enters Phase III of its cycle.

What He Said:

“Consumer confidence does not change overnight. In the U.S., 70% of GDP is based on consumer spending. And in my life, all the recessions I have seen or studied have only come to an end when consumers started spending. With consumer sentiment getting worse, and with the U.S. personal savings rate at near record lows, it may take two or three years for consumers to start spending again.” Michael Lombardi in PROFIT CONFIDENTIAL, February 25, 2008. By the end of 2008 the rest of the world was realizing that the recession would be much longer and deeper than most had realized.