A rally in stocks is when prices rise for an extended period of time. This is due to the fact that there are more buyers than sellers of stock. Once the supply of shares at any one level is exhausted and more buyers are willing to accumulate shares, the remaining sellers raise their price at which they would be willing to sell their holdings.

The key index that provided extra gas for the most recent stock rally was the Dow Jones Transportation Average, and it did so in the face of higher oil prices. This was excellent confirmation and its recovery from late February was necessary in order for the stock market to keep on going up. The Dow Jones Transportation Average’s technical picture still looks good and, despite some investors’ view that this index is “old school,” I keep following it for confirmation of the main stock market trend. In my experience, it works. (See Stock Market: The Good News for 2012.)

We’re on the cusp of a new earnings season and the current stock rally will now be based on event-driven, corporate news. The stock market has already placed its bets and investors are already expecting good first-quarter earnings reports. Corporate visibility will be very important and corporate expectations for the rest of the year will make or break this year’s stock rally.

After first-quarter earnings season is over, I expect some sort of correction. It would be very unusual not to have a price correction after the broader stock market appreciated so much in a short period of time. The only catalyst that would keep any correction short-lived would be much improved economic news. If we get much better economic news on employment and housing, then this year’s stock rally should continue with fervor. Investor sentiment among institutional investors is strong enough.

I continue to be amazed at the specific stock rally in large-cap technology shares. A lot of the big, brand-name companies like Microsoft Corporation (NASDAQ/MSFT), Intel Corporation (NASDAQ/INTC), Cisco Systems, Inc. (NASDAQ/CSCO), and Apple Inc. (NASDAQ/AAPL) have been stock market powerhouses since the beginning of the year. The technology sector has carried the rest of the stock market until now. Recently, we’ve had very solid price strength in large-cap financials and with the recovery in the transportation sector;  it’s easy to see how the S&P 500 Index got above 1,400.

I think there is good momentum going into the second quarter, on the stock market and in the Main Street economy. The retail sector is much improved and job numbers are slowly getting better. But, keep in mind what the stock market is good at—betting on the future. The current stock rally is due for a break and shouldn’t advance further unless the news is better than expected.

The Federal Reserve is basically responsible for orchestrating this year’s stock rally. Monetary certainty regarding low interest rates for an unprecedented period of time is what changed investor sentiment at the beginning of the year. The possibility for sovereign debt-related problems next year is great. So is the potential for another war. Perhaps the greatest investment risk on a medium-term basis remains the threat of price inflation. This is the one risk that could bring any stock rally or economic recovery to an abrupt halt.

There is a good possibility that the stock market will experience a major retreat/correction in the near future, as it has done so over the last two years starting in late spring. It’s related to the old stock market adage, “Sell in May and go away,” and it’s likely because the current stock rally has been going on very consistently since the beginning of the year.

This is another reason why I’m not very enthusiastic about being a buyer in the stock market at this time. A big change in investor sentiment at the beginning of the year fostered the current stock rally, aided by the Federal Reserve, temporary action on Europe’s sovereign debt crisis, and reasonable stock market valuations. The market expects good results this earnings season, as well as decent visibility. Without it, the currently stock rally will be over.

Even with good corporate news, this is a stock market that’s in need of a break—just like precious metals a little while ago. A lot of good news is now priced into stocks and I think it’s likely this year’s stock rally will take a break in the next month or so for the rest of the summer. Then, before the election, the stock rally should resume its final leg. That’s my best guess for the rest of this year. For 2013, all bets are off.

Without question, investors do not need to be buyers in this market. It might seem odd for a stock market analyst to advocate not investing in a stock rally, but the current environment is a time to reap, not sow new positions. A stockbroker always advocates taking on new positions when his or her clients “have the money.” But the current trading action suggests to me that a correction is on the horizon. Trading volume is declining and institutional investors have already placed their bets ahead of first-quarter earnings season.

I expect the S&P 500 Index to form a top in the fourth quarter this year, possibly early in 2013. The road for stock market investors has been pretty smooth this first quarter. It should be increasingly bumpy as the election approaches. I reiterate my view that a conservative investment stance is warranted and that this year’s stock rally should soon experience a correction. If the price correction is strong enough, I would consider adding to higher dividend paying stocks and some more gold/silver exposure as well. (See Why the NASDAQ Blasting by the Dow Jones Is Another Positive Signal.) It is my view that, next year, the sovereign debt crisis in both Europe and the U.S. will haunt stock markets around the world. It is getting to be time for governments to start paying the piper.

Very near-term, investor sentiment is strong enough to carry this year’s stock rally further. The financials report first and, if their news is good and dividends go up, the stock market will move higher. Expectations are strong in the technology sector and these companies will have to prove themselves. As far as the industrial’s are concerned, they are likely to keep reporting solid earnings growth.

I’m not bearish on the future, only realistic. A correction followed by a resumption of the current stock rally is my outlook for 2012. I also believe that the stock market is in the process of topping out and that the U.S. economy is due for another recession soon.

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?

With the year-end in sight, it will be interesting to see if we get a Santa Claus Rally—a situation in which a stock rally occurs between Christmas and New Year’s Day.

The month of December has historically been positive for stocks, so if you want to play the percentages, buy stocks now and ride a possible stock rally.

The odds for success are way better than what you would find in Vegas.

The S&P 500 edged higher in December in 45 years, while declining in 15 years since 1950, according to the Stock Trader’s Almanac. The average gain for the index during this time was 1.6%. But the index stock rally this year could be higher, as this is a pre-election year. The S&P 500 has returned 3.30% in this situation in the past.

If you like small-cap stocks, take note, as small-cap stocks tend to have a stronger stock rally than big-cap stocks beginning near the mid-point of December. That’s next week. The Russell 2000 has advanced an average 2.7% over the past 31 years, including 24 up years. And, in pre-election years, the results have been stellar, with the Russell 2000 advancing 4.4%.

But, for the best stock rally gains, technology has fared the best, with the NASDAQ up 5.4% in December in pre-election years.

At this time, the eurozone still needs to ratify the debt plan, which is placing some pressure on stocks. Standard & Poor’s placed each of the 17 eurozone countries on watch and said there could be rating cuts to each with the exception of Germany. The reality is that the problems in Europe are not going away. Even when a resolution is finalized, there will be continued growth problems in Europe down the road. The chart of the top 350 European companies shows the absence of a stock rally in European stocks.

With the recent stock rally, the 200-day moving average (MA) is the target. The S&P 500 advanced 7.4% for the week to December 2; nevertheless, the index closed lower in all but three of the last 12 sessions. The broader market continues to hobble along, but has advanced from August.

The key stock indices rallied after trading lower at their respective 50-day MAs, but the 200-day MA will be a crux to overcome during a stock rally. Only the DOW has managed to break its 200-day MA. About 36% of all U.S.-listed stocks remain below their 200-day MA at December 6. About 67.5% are above their 50-day MA, down from 75.43% a month earlier.

Over the next few weeks, the retail sector will be highlighted. A strong push will drive up the fourth-quarter GDP and give a lift to stocks heading into 2012. The early signs have been positive. There were record sales of $52.4 billion on Black Friday along with a strong Cyber Monday. The optimism was supported by a surprise jump in the Consumer Confidence for November to 56.0, which was above the estimate of 42.5 and the revised 39.8 in October. The strong reading suggests that consumers may be feeling better.

The chart of the SPDR S&P Retail Index shows a bullish double bottom followed by a subsequent rally back to the recent highs.

December is looking good; if the eurozone can sort out its mess, a stock rally could materialize into January. The odds favor going long the stock market.

While stocks look positive for December, I’m not keen on the housing market as we move into 2012, as I discussed in Home Sweet Home? Not for the U.S. Housing Market.

I’m also not keen about our massive debt load, never mind the debt crisis in Europe. You can read why this country has a lot of work ahead of it in America, Time to Talk About Our Debt.

That’s what I like! An obedient stock market!

Since the beginning of this year, I have been saying that I expect the bear market rally in stocks that started on March 9, 2009, to continue in the immediate term. And the stock market has been doing exactly as I asked. Good work, if you can get it!

This morning, the Dow Jones Industrial Average opens up 1.5% for 2011. That’s a gain of 1.5% in eight trading days. At that pace, the Dow Jones Industrials will gain 48.75% this year (and we both know that’s not going to happen)!

You can’t fight these facts, nor should you trade against them:

• Since March 9, 2009, the Dow Jones Industrials has gained 5,315 points, or 77%.
• The Dow Jones Industrials is at its highest level since January 2008—24 months ago!
• In respect to sectors, the Dow Jones U.S. Technology Index has been the best performer. It sits at a fresh, new five-year high this morning. The Dow Jones U.S. Financial Index (primarily the bank stocks) is still down 50% from its February 2007, high.

So it’s been a great rally for stocks. And I still don’t think it is over in the immediate term. This is based on two underlying principles that have dictated my investing strategy very successfully over 30 years: “You don’t fight the trend,” and “You don’t fight the Fed.”

History is full of casualties; investors who bet against a prevailing trend and lost. If the Federal Reserve and the government are maintaining expansive monetary and fiscal policies (like they have since the spring of 2008), you don’t trade against their actions.

The amount of support for the financial system and the economy that the Federal Reserve and the government have delivered over the past 22 months has been unprecedented. Bank bailouts and zero interest rates…even big industrial companies got bailouts or loans.

Stock markets go up during periods of expansive monetary policy. They go down when the Fed implements a contractive monetary policy. The single, biggest factor behind the stock market rally of the past two years has been the support of the Fed. Interest rates being record-low have enabled corporate America to deliver solid profits to their shareholders again.

But, at the same time, I’m a contrarian investor. I don’t like the fact that my friends are talking a lot about the stock market again. And I’m certainly not a fan of these reports I get showing that stock market advisors are at their most bullish level since 2007.

The stock market always delivers the opposite of what is expected of it. This time won’t be any different. Look at all the investors that jumped on the gold bullion bull market bandwagon in late 2010. They’re now wondering if they made a mistake (we need a good old-fashioned correction in the gold bull market to wash them out).

Eventually, the Fed will tighten their monetary policy, if for nothing but to support an ailing U.S. dollar and to fight inflation. Long-term interest rates are already up sharply since this past October despite the Federal Reserve’s Quantitative Easing Part II program.

My readers should continue to enjoy this stock market rally in the immediate term, because it will not last.

Michael’s Personal Notes:

Very little is being said about the surge in world food prices. My readers should be aware of it, as I see this as a prelude to unexpected rapid inflation.

According to the Food and Agriculture Organization, an agency of the United Nations, world food prices rose to a record in December of 2010. Sugar and meat costs were the biggest gainers. As a group, the 55 food commodities tracked by the agency were up 25% in price in December 2010, compared to December 2009.

What’s causing food prices to rise so sharply? Two answers: Rising demand from middle-class consumers in India and China and the worst drought in Russia in 50 years.

Because the world population is expected to expand to 9.1 billion in 39 years from the 6.8 billion people in the world today, the Food and Agriculture Organization says that worldwide food production will have to rise 70%. As time passes and global warming and other issues come into play, I see food production actually declining, not increasing.

Rising food prices are a real problem today—they will be a bigger problem in 2050. Those economists still stuck on the idea that deflation is a concern for our economy need to get on the right track. Inflation will be the real problem in 2011 and 2012, not just because of rising food prices, but because too much liquidity in our financial system continues to debase the purchasing power of the U.S. dollar

What He Said:

“The proof the party is over in the U.S. housing market could not be clearer to me. The price action of the new-home builder stocks is telling the true story—these stocks are falling in price daily (and the media is not picking it up). Those that will hurt most when the air is finally let out of the housing market balloon will be those buyers that bought in late 2005. In fact, the latecomers to the U.S. housing market may end up looking like the latecomers to the tech-stock rally that ended so abruptly in 1999.” Michael Lombardi in PROFIT CONFIDENTIAL, March 1, 2006. Michael started warning about the crisis coming in the U.S. real estate market right at the peak of the boom, now widely believed to be 2005.