Stock Market Rally Is for Suckers as Credit Destruction Lingers

Since the S&P 500 Index and MSCI World Index hit their intermittent lows on March 9, stocks have been enjoying a period of strong gains, low relative downside volatility and rising inflows into stock mutual funds. From their lows four weeks ago, stocks are now up a cumulative 24.5%, including the gains in S&P 500 futures ahead of this morning's open.

Indeed, the CBOE Volatility Index or VIX continues to decline since hitting an all-time high last November.

The VIX, which measures options trading sentiment on the S&P 500 Index has crashed from a high of 80.86 to 38.85 ahead of Thursday's trading, a 52% decline. If the VIX closes today below 38.50 - highly probable - then I'd view that as a bullish signal for the short-term direction of the markets.

Declining Volatility Short-Term Bullish

Over the last few weeks, global economic data has revealed a marked improvement in the flow of bad news. Whereas the statistics were just outright awful and literally plunging over the last several months, the data since early March portend to a slower rate of economic contraction.

The stock market is now crossing important territory this month as first quarter corporate earnings begin in earnest. With the FASB engineering a hocus-pocus act on bank earnings last week the market is expected to get a boost from the new trend in phony financial services accounting. This will give the market an additional boost this month.

Combined with better earnings guidance from companies, which I view as almost impossible in this environment, might be enough to propel stocks even higher.

A key index level to watch for a new break-out is Dow 9,015.10 and the Dow Transports at 3,717.26; if these indices break through these important resistance levels then my intermediate and long-term bearish view on stocks will be violated. Until we crack these thresholds, this is still a bear market rally.

I don't believe this will be a normal cyclical economic recovery, regardless of what the stock market does. The stock market is largely manipulated by sleuths whereas the bond market is largely dominated by the "smart" money. And the credit indicators tell me that we're a long way from bottoming in this credit cycle - especially in several markets that are not currently assisted by the Fed and Treasury. Basically, high quality credit spreads have not narrowed since the commencement of this stock rally. This is bearish price action.

I've never experienced a debt deflation. Nor have most people currently alive. It is unwise and foolish to treat this bear market like any other in the post-WW II period because it is totally unique; the scope and depth of the ongoing destruction of consumer and business credit, bank balance sheet compression and insolvency, consumer retrenchment and soaring unemployment should not be underestimated. The rare nature of this recession precludes a cyclically normal U.S. recovery.

This is a time for investors to largely preserve capital and wait for the market environment to improve as it pertains to government regulation and the future of our banking system. Many questions are still unanswered or unresolved. Simply, it is not clear how the new financial landscape will emerge in the post-2007 credit bear market and as a result investors should tread cautiously dollar-cost-averaging equities and not making any lump-sum investments. I would focus your long-term equity purchases on large-cap U.S. stocks, the emerging markets (China and Brazil mainly) and Asia, including Japan.

But the bulk of your assets should be targeting high quality short-term investment grade debt, convertible bonds, TIPS, mortgage agency debt, senior Canadian bank debt and, once the dollar finally pops, foreign currency bonds. Also, I have no doubt that gold will eventually regain its footing and head through the roof once deflation is quashed. We're all going to pay dearly for this monster-sized spending - clearly out of control at this point.

In the 1930s the Dow posted several major bear market rallies before finally bottoming in June 1932. The current rally - now the third such period of gains since early 2008 - has room to advance because of the massive amount of concerted global fiscal spending now hitting the financial system and eventually, the real economy. But like a drug addict that needs his fix, this recovery will require another dose of spending in 2010 as government stimulus fails to supplant consumer spending indefinitely. The consumer will not save the day as he remains focused on balance sheet repair and cash savings.

In the absence of a global consumer now that the United States is raising its savings rate, there isn't one nation that can supplement U.S. imports. This implies major hurdles for the global economy and therefore corporate earnings, as we look beyond a blip in economic activity the second half of 2009.

This bear should not be underestimated. The destruction of credit and wealth has not passed its peak but rather is taking a time-out before feasting again on the financial system perhaps later this year or in 2010.

Comments

[investor88:]

Agree the under bely [fundamentals] of the stock rally is rather soft. Hence enjoy the rally by all means, trade with stop loss because the market being the market may yet surprise on the upside.

Dow 9015, transports 3717 resistanace breached= new bull trend. Fair enough we will have to see.

Meanwhile, a worthwhile long trade even if Dow were to approach 9k then reverse. Author has stated Vix below 38.5 short term bullish, and this condition has been fulfilled with Friday's Vix close of 36.

Apr 12 05:54 AM

[morph366:]

Your diagnosis of the patient (i.e. the economy) is correct
i.e. The rare nature of this recession precludes a cyclically normal U.S. recovery.
But given the massive injections of anti-depressants and the flood of "Get well soon" messages, coming in from pension fund managers and insurance companies sitting on 30-40% losses from last fall, this rally/bubble could have a way to go yet.

Apr 12 08:49 AM

[Brekeen:]

I would sincerely hope that after we experience the GREATEST RALLY since the Great Depression that you consider retiring your editorial.....DOW 13000; S&P 1300, U.S. dollar at an all time low in the $0.70 range; Gold $1500.00, Oil $80-$90...Comodities and Mining Company shares almost a vertiacally ascent....I could go on but you get the picture....after 2009 probably before in fall we enter a slow tedious Bear market lasting almost 2 years....what flavour of loli pop do you like? Too many inside the box editorialists...great for any True Contrarian however....

Apr 12 09:25 AM

[a. palmer jr.:]

It seemsyou are recommending everyone hold their money in "safe" vehicles and stay out of the markets, wouldn't that just freeze the markets where they are, assuming everyone takes that advice?

Apr 12 10:03 AM

[ArkansasAngie:]

Being an entrepreneur has taught me many things. One of them is I have a much bigger appreciation for and more personal relationship with risk.

When and where the rubber hits the road, I am willing to put the ante in and play my hand because I know that I do control at least my own actions. On the other hand, I have no control of nor have real input into the market. It doesn't care what I think or do. So ... I try to bet the trends.

Right now there are no trends to bet.

Until and unless uncertainty declines, there will be no clear trends.

For example, I'm not going to take out a 5 year note and be personally responsible for it unless I can visualize how I'm going to pay for it in a worst case scenario. Cutting my teeth in the dotcom era as president of an internet startup; I take computer generated income scenarios with a grain of salt.

Net, net, net ... the prudent investor isn't in this market. It's speculators and program trading.

Apr 12 11:22 AM

[dcb:]

I think this is the start of a bull rally. although the bull has been fabricated by the government and industry. it could run 5 years, eventually if it is a credit based rally it has to bust again, until we move away from a credit based system it aint going to be sustainable. Volker got tid of the credit in the system in 82, therefore we had a rally until the dot com bubble. Greensspan reflated credit, it lasted 6 a number of years then blew up. if we embark on same pattern, we will see same pattern. Much of what happens in the market is determined by what kind of system we end up with.
I do not want to see a credit based system. I think it is going to get shoved down our throats because it involve less pain a does the most to protect vested interests.
Like the 70's to the 80's we could easily see the same pattern. I think inflation will have to get out of hand before any real cures are done.

Apr 12 12:23 PM

[Gtarras:]

"With the FASB engineering a hocus-pocus act on bank earnings last week the market is expected to get a boost from the new trend in phony financial services accounting. "

Count on it.. I am the one who is forced to calculate and report bogus negative MTM results at a desk (look at my prior posts, i've been pounding on FAS 157 over the past 6 months).. Guess what, hocus pocus act is the one we had PRIOR to last week.. Keep dreaming that the rally will stall...

Apr 12 12:24 PM

[Northstar10000:]

Cetin says
The rally is for real. I don't think Cetin has a clue about what is really going on. the Fed is scared out of their pants and rightly so.
AIG will bring the whole thing down in 2010. follow Cetin and take a beaten !! Enjoy the rally but get out and let Cetin People hold the bag.
We need bag holders so we can get out. Thanks guys,

Apr 12 02:30 PM

[Prudent Man...:]

Remember that the market went up while the economy was collapsing. Anyone willing to accept the risk must not expect any more government bailouts as the well is running dry.

If you go in the market I wish you the best. I am a military veteran who is pro-American, though I know all in our government are not, and want to see us, and those who invest, succeed. But, realistically I believe we must return to the Free Enterprise System and have sufficient regulations to keep it free from Crony Capitalists and Socialists. Unfortunately, I do not see that on the horizon.

Apr 12 03:08 PM

[jdl51:]

"In the 1930s the Dow posted several major bear market rallies before finally bottoming in June 1932."

I thought FDR made the Great Depression worse with his policies? Check a GDP chart of the 1930's and it did, indeed, bottom in 1932-33, right when he took office, and began a steady rise with a slight recession in '36 and '37, rising again even before the war past pre depression levels. Another con myth busted.

Apr 12 03:21 PM

[fran:]

very few large market players read SA. not to worry about market freeze. life beyond SA will go on.


On Apr 12 10:03 AM a. palmer jr. wrote:

> It seemsyou are recommending everyone hold their money in "safe"
> vehicles and stay out of the markets, wouldn't that just freeze the
> markets where they are, assuming everyone takes that advice?

Apr 12 03:39 PM

[InvestBaboo:]

What is funny is how these diehard bears keep raising the targets to prove that this is really a bull market and not a bear market rally. Golly, now the new target is Dow 9015! Apparently the author accepts to be disproved if the rally can cross 9015! After hitting 9015 another new target will be established perhaps in the Dow 10,000. Eventually these bears will get in at which time I suspect the charts will flash a sell signal allowing those on board to get out and leave these bears as the bagholders.

Apr 12 05:40 PM

[ifuwish2:]

i cant believe all the bull i read that you guys write,,well if you guys had a clue it would be a dangerous worls we live in,,get a reality check and report the truth instead of gloom and doom what you guys are hoping for more of and i think you guys like that,,pityfull

Apr 12 08:31 PM

[fredissy:]

I don't know about his numbers...all technicians have numbers, just take your choice. But, his premise is right on. Mama always told me that money doesn't grow on trees. That is true. But, money does grow in the US Treasury. Mama didn't know crap about that. She lived in a world when credit was hard to get, and people lived simpler and more fruitful lives. They lived within their means. As a child , I used to make toys out of stones and little pieces of wood. I used to play in the dirt....I played in the dirt a lot. I am 75 and hardly ever am I sick.....I wonder if playing in dirt had anything to do with that?
No, I don't know if his numbers are correct, but his premise is. A society cannot print, borrow, and spend its way to prosperity. And bring up our children in a totally clean environment where they can be a comfortable 50 pounds overweight doesn't seem to bode well for our future either.
Our society, our economy, our markets, and our general well being, are all headed for HELL. The only question is......How long will it take

Apr 12 10:59 PM

[freefall51:]

Last time I checked HELL was forever.

Apr 12 11:42 PM

[Rob Viglione:]

Real credit markets cannot improve without prerequisite savings. This will be a long, painful process. The American consumer will no longer be able to borrow to buy Asian goods, at least to the extent seen in the past. Those days are gone and our economy is just now shifting to a new reality.

Until this new reality sinks in I suggest taking profits off the table and putting them into less risky ventures.

Apr 13 01:05 AM

[Roger Knights:]

It's all downhill from here.

Apr 13 04:54 AM