INVESTING: Markets seem to hold bears at bay as bulls run ahead

As this rally hums right along, let’s check under the hood to make sure there aren’t any gremlins lurking that will eat all our profits. We can look at this as a diagnostic check for you engineering types.

The sell-off that began in early January for the NASDAQ and in March for the rest of the market bottomed out in mid- to late April, with a mild retest that finished on May 8. This correction brought the major indexes down anywhere from 8 percent to 15 percent for 2005. Investor fear levels were exceptionally high by the middle of April and many experts were calling for the beginning of the next bear market.

My, the stock markets look a lot better today, eh? Fear has fallen to neutral levels and the major indexes have put on an impressive run in the last two months. The Standard & Poor’s 500 is less than 2 percent below the rally high posted March 7, and the S&P midcap index just hit a new all-time high.

That’s right, my favorite sector of the market-the mid-caps-is the best-performing index in 2005.

Tech stocks are still about 5 percent off the highs from early January, but they have absolutely lit it up since May.

The good news for the bulls is that many of the internal indicators are matching the strength seen in the price advances of the S&P large and midcap indexes. Sellers don’t seem willing to get rid of their stocks. It is these weakly motivated sellers who are allowing this market to almost float higher. The Dow Jones industrial average and the S&P should set new rally highs soon.

One of the themes I have consistently talked about since the start of this year is an expected narrowing of participation as this bull market ages. This exact scenario is playing out.

Since the market bottomed in April, the NASDAQ 100, the largest NASDAQ issues, has recovered over two-thirds of its decline and the advance/decline line for the index has recovered the same amount. NASDAQ midcap issues have also recovered two-thirds of their decline, but the advance/decline line for that index has recovered only half of what it lost.

The small-cap NASDAQ stocks have recovered only 50 percent of their losses, but the advance/decline line for that index has recovered only 17 percent!

Remember what I have been saying all year: Investors are swimming upstream. They want larger and more liquid names, and they are more willing to sell the small stuff.

For the remainder of this bull market, investors need to place a higher value on liquidity, and also be willing to part with underperforming stocks. Lately, the underperforming stocks are likely to take the form of smaller companies. That’s OK. Investors need to roll with it if they are going to keep up with what the market is doing. Almost every bull market in the last 100 years ended with investors favoring larger, more liquid stocks. I don’t expect this time to be any different.