3 Signs of a Near-Term Market Advance

Last Tuesday's big stock market surge has some serious near term technical analysis legs under it. And the prospect of an attempt to rise to the S&P 500’s 50 moving average (just under 1100) looks achievable. Yet, there are also three non-technical analysis reasons supporting a sustained near term advance – calendar related events, market factors, and valuation considerations. Here are a few thoughts on each.

Calendar related events

1 - While all eyes will be justifiably fixed on the election results of November 4th, another November date, the 15th, contains its own stock market importance, for it is on that day that the global economic summit takes place, which should provide a reasonable psychological boost to investors as the image of coordination and cooperation between and among the major developed country players provides its desired impression. Then there is the other aspect of November 15th that should benefit the markets.

2 - November 15th is the mid zone date (between 60 and 30 days before the end of the year) for hedge fund investors seeking to redeem their interests for this year. Alleviation of redemption induced forced liquidations (a major factor in this month's indiscriminate selling) will help all financial assets.

3 - Finally, November is the month when all the government programs agreed to (TARP and the commercial paper program, for example) begin to kick in. It is when the US Treasury and other governmental bodies worldwide begin to walk the talk.

Market factors

1 - According to several sources, there is more than $3 trillion in cash sitting on the sidelines. As of the end of August, this number represented 30% of the total S&P 500 market cap, a percentage that equaled the bottom of the last bear market (October 2002), and a percentage that is no doubt substantially higher today (conservatively estimated at just around 40%). That’s a lot of capital waiting for the right catalyst.

2 - When measured on a one year basis, the drop in the US equity markets is now a record percentage decline over the same time period for the last ten bear markets. At greater than 40% down, the one year decline rivals the worst of all previous such declines. This was further noted by former Merrill Lynch Chief Market Analyst Bob Farrell when he recently wrote,

The current bear market decline is already as extreme or more extreme than other major downtrends in history. Here in October it has included other asset classes as well, such as commodity markets, emerging markets and the currency markets. Deleveraging has essentially caused asset implosions in all markets globally despite the attempts by governments to provide support and liquidity. We have to go back to the 1930s or even the beginning of the twentieth century to find examples of volatility and market extremes comparable to today.

Valuation considerations

1 - You don’t need me to tell you that many stocks are at outrageously attractive valuation levels. None other than Warren Buffett has taken care of that viewpoint. What may be of broader investment strategy interest is the fact that only a depression-style deflation scenario justifies equity values below current price levels. As noted in this week’s Sectors and Styles Strategy Report (published before the jump this week): “Even under a strong recessionary scenario of 12.5 times $72 (= 900), the current S&P 500 price produces a positive return. Only a deflationary scenario puts the current market level at overvalued." And a deflationary scenario means 8 times $60, or an S&P 500 at 480. Although in this climate anything seems possible, given the massive sums of capital being pumped into the system, it is hard to envision deflation taking hold beyond the asset class destruction that has already taken place.

2 - Last point to make is the fact that while global growth is slowing, a global recession is not the base case. All the data suggests that emerging economies will weather this storm in fairly good shape and they will emerge as the demand engine of growth. One could argue that they will be the one area where many investors will gravitate to as growth in developed economies remains below trend and potential.

Investment Strategy Implications

For all the reasons noted above, stocks seem poised to make a run at their downtrend moving averages, which in the case of the S&P 500 is just under 1100, or another 15% up from current levels.

Comments

[investor88:]

OK Dow 1100 = 15% up from present levels is the target for this run. Looks like a tradeable rally what with the Nov 15 world summit. The reasons given for a positive outlook listed in this article are quite valid. Maybe a stab at the markets is ok with stop loss and sell stop.

2008 Nov 03 06:54 AM

[kotika98:]

My friend, 72 in S&P earnings this year or even next? What are you smoking? I say 50-60. Remember, about 20% of earnings in the S&P are due to oil companies, and that just went out in a puff.

2008 Nov 03 10:30 AM

[DavyJ:]

Where do you suppose that $3 trillion in cash came from?

Not from investors selling their stocks since for every seller who now has cash, there was a buyer who now doesn't have an equal amount of cash. No net change.

Not from new money generated from savings. $3 trillion represents more than 20 per cent of U.S. GDP of something less than $14 trillion. The U.S. is not a nation of savers.

Not from foreign government reserves. That money is already committed to treasuries or other investments, U.S. or otherwise.

So, where did it come from? And when it enters the market, won't an equal amount exit? Buyer Mort's cash now becomes seller Mert's cash. Again, no net change.

2008 Nov 03 11:55 AM

[Jim Faber:]

Nice article but here's a question:

If profits fell just over 50% peak to trough during the last downturn, given the extraordinary circumstances this time around why should we not believe they could fall by at least that much (if not more) now?

That would put the S&P at just over 23 times forward earnings at present so on that basis, I think we need to consider the possibility that stocks are relatively expensive.

2008 Nov 03 12:56 PM

[Jim Faber:]

Just adding a thought to the above:

Stocks didn't begin the rally to the Oct. 2007 peak until the first quarter of 2003. Not only was that well after the recession ended, it was also well after earnings crashed and AFTER they had already risen over 21% from the bottom.

So while a short term bounce is always possible, if history repeats stocks won't begin a sustained rally until after earnings crash and after they once again have a show of strength.

2008 Nov 03 01:02 PM