Why You Shouldn't Bet on a Rally
By Jeff Clark
October 30, 2007

Shares of both Merrill Lynch (MER) and the semiconductor index (SOX) broke down badly last week. And that puts the whole idea of a year-end rally into question.

Of course, the broad market indexes can still rally without the participation of MER and the chip stocks. But the odds are against it.

This really does create a bit of a quandary...

You see, most stock charts look bullish to me. The semiconductor stocks are as cheap as they've been in years. And, we're entering a consistently strong period of the year for stock prices. Add to that the potential for further interest-rate cuts from the Fed, and you have a very powerful argument in favor of higher stock prices.

But there's something that's just not quite right.

I keep thinking about this past June and July, when I was harping on the underperformance in MER shares and how that was an albatross around the neck of the stock market. Yet the market kept moving higher.

Stock prices refused to fall, and that had me questioning the validity of MER shares as a leading indicator. Instead of aggressively selling stocks short, I started thinking that maybe it was different his time. Maybe the action in MER wasn't a warning sign.

Of course, we all know what happened in August, as MER once again proved to be Wall Street's canary in the coal mine.

So now, as we head into what is typically the most bullish time of the year for stock prices, MER is once again underperforming. And the semiconductor stocks – which are as cheap as they've been in years – can't catch a bid.

I desperately want to be bullish right now. I want to tell you to load up on stocks in anticipation of a year-end rally. I want to write that we are on the verge of a major upside move that will last several months and power all the major indexes to new highs.

But I can't.

The two things we needed last week to set the stage for a rally were a pop higher in MER and a rebound in the chip sector. We got neither.

In fact, both of those indicators went sharply in the other direction. The SOX index lost almost 5% on the week. And MER was down more than 10% for the week before rumors of the CEO stepping down sent the stock sharply higher on Friday.

So do we argue that it's different this time and these two leading indicators are no longer useful? Or do we look at is as a caution sign and a reason to be suspicious of any further move to the upside?

I'll take the latter.

Best regards and good trading,

Jeff Clark