How High Can Stocks Go?

With global economic activity exceeding low expectations and the Fed stating the threshold is high to scale back its money-printing program (QE2), it is a good time to examine the upside potential of the stock market. While the average investor has a limited memory when it comes to market reversal points that occurred in 1998, computers and trading algorithms have no trouble recalling them in vivid detail. Therefore, taking a little walk down memory lane may help us compete more effectively with the largest firms on Wall Street.

On a side note, for those of you focusing on bullish sentiment levels, it is interesting to point out these concerns started to surface around November 9 (see one example here). With many sitting on the sidelines, primarily based on elevated sentiment, the S&P 500 has moved from 1,213 to 1,273 for a gain of 5%. Some additional comments related to sentiment can be found in the last paragraph of this article.

While this analysis is based on the S&P 500 (SPY) Index, it indirectly applies to all economic expansion and inflation-protection assets, such as copper (JJC), oil (USL), silver (SLV), and gold (IAU). If stocks are making higher highs, inflation-protection assets will most likely come along for the ride.

We study the S&P 500 since it remains the most widely-accepted vehicle to monitor market participants’ acceptance of or aversion to risk. Similarly, the S&P 500 helps us monitor the ongoing battle between global inflationary and deflationary forces. When money printing and economic expansion rule the day, the S&P 500 tends to be healthy. When excessive levels of global debt, unfunded entitlements, bloated housing inventories, and economic weakness are front and center, the S&P 500 tends to be weak.

As we outlined in our 2011 Investment Outlook, the S&P 500 recently cleared several key levels, which leaves the door open to the possibility of higher highs in stocks. This analysis looks at market levels that piqued the interest of both buyers and sellers between 1998 and 2011. We studied weekly and monthly charts, looking at intra-day highs and lows, as well as closing prices. The table below summarizes the results, focusing on market levels that have the highest probability of impacting asset prices.

The chart below highlights important levels from a monthly perspective. There are numerous ways to determine possible areas of support and resistance. Therefore, other levels may, and most likely will, come into play over the coming months.

The same concept is presented below with a different time frame. Notice that, according to the right side of the chart, the present day market may have some more room to run in terms of the most relevant levels of resistance.

The analysis above can help bulls and bears alike, since it identifies areas of possible support should market participants begin to refocus their attention on the deflationary side of the coin. The market’s upside potential, even under positive circumstances, may not be met until some form of corrective activity or consolidation takes place. Bullish sentiment needs to be monitored and remains a yellow (not red) flag for the markets.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.