Why Stock Markets Are at a Crossroads

by George Leong, B. Comm.

The oversold buying that surfaced on Monday was encouraging. It was an excellent day for stocks on Monday, with a strong intraday upside trend and the major indices breaking back above key breakout levels (NASDAQ, 1,700; DOW, 8,400; S&P 500, 900-950; Russell 2000, 475). Market breadth was extremely strong and investor sentiment was bullish. Prior to Monday, there was near-term top selling, as the major indices were correcting. The Russell 2000 was down 7.23% from its recent high, along with the NASDAQ at 5.25%, DOW at 4.50%, and the S&P 500 at 5.16%.

What happens over the next few weeks will be an important factor in whether we have a rally or whether stocks will drift lower.

In my view, the fear is that the selling could turn into a sustained downward trend and further losses. What you want to see is a bounce. What is important is that a downward trend does not materialize. The failure to break higher could see the major indices drift in a sideways channel for the summer months, which tend to have lower activity.

The important thing is that stock markets are presently trading at a crossroads after rebounding over 30% from the March lows. I feel that there still is above-average market risk, with stocks remaining vulnerable to downside moves. A move back to the March lows is possible, especially if the economy does not improve sufficiently and the jobs and housing areas continue to be under duress. Housing construction in April was at a record low.

Markets need to see some leadership. Financials had been providing some leadership during the recent rally, but there remains risk in that group. In the banking sector, we are seeing some profit taking after some stellar gains over the past several weeks. There are dilution concerns with the bank’s stock offering plans aimed at increasing capital requirements under the government’s Stress Test. Yet the situation appears to be improving, as far as some banks being set to begin to pay back some of the TARP funds.

Technology continues to be the leader this year. Traders will always pay for innovation and the next new great application. Even during slowing periods, technology companies continue to invest heavily in research and development, as they need to generate new ideas to vault ahead of competitors or to stay close. For instance, it would not make any sense for chipmaker Intel Corporation (NASDAQ/INTC) to suddenly reduce its chip development and let rival Advanced Micro Devices, Inc. (NYSE/AMD) advance. That is why technology will always be a strong investment.

In technology, look for the market leaders in each area as core
investments. To add some growth and increase your return, you also need to buy technology companies on the verge of becoming big, such as those in the mid-cap area. And to really add some risk and the chance for some spectacular returns, add some small-cap technology stocks that have great technology but may be just starting to take off. Under this scenario, you can increase your overall returns but at the same time generate some diversification to your portfolio.