The Nature of the Current Market Rebound

In observing the current stock market rally, stocks leading the way are not the high quality companies with solid balance sheets and good prospects for growth but are the most beaten down troubled entities. We are confident that this is not an investors’ rally but rather a traders' rebound where much of the upside volume is due to short covering.

The banking sector has been the unquestionable leader in the rebound over the past six week. The sector has outperformed not only the S&P 500 but the NASDAQ 100 by a wide margin.

However, despite the reports that big banks are beating street estimates this earnings season, a closer look at earnings paints a rather dull picture.

For the most part, positive surprises are related to banks’ trading activities and to the retroactive change in the application of the mark-to-market accounting rule. Most of the core businesses of these major banks remain in very poor shape.

And could it be any other way? The level of unemployment today is close to a 30-year high and will most likely reach 9.5%-10% by the end of the year. In California (the sixth largest economy in the world) the unemployment rate is already at 11.3%. In the past five months, United States lost an unprecedented 3 million jobs.

For the unemployment rate to stabilize, the economy would have to grow by 2.5% to 3.0%. In the fourth quarter of 2008, the economy fell by a 6.3% annual rate, while consensus forecast for the first quarter of 2009 now stands at a negative 5.0%. First quarter figures are due to be released on April 29^th. In our opinion, a return to sustainable growth of 2.5% to 3.0% will not occur sooner than in two or as much as five years.

As a result of a sharp decline in the real estate market as well as the stock market, there has been a tremendous fall in household wealth over the past twelve months. This compares to no other time in the post-World War II period. Consumption is declining but rather slowly as people are dipping into their savings or raising their debt levels to try to avoid the inevitable decline in their standard of living. Consumer spending will continue to decline and may do so at an accelerated pace in the coming months as unemployment continues to increase.

It is hard to find a silver lining among all of these bad economic developments. In the corporate America, earnings have fallen off a cliff. Further declines are likely for another two to three quarters.

Falling earnings with little prospects for a quick recovery combined with rising stock prices are all characteristics of the bear market rally.

From a technical perspective, six weeks of rising stock prices have caused the S&P 500 to reach its first important resistance level of 875. For the short term, there are two most probable scenarios:

1. Since the NASDAQ 100 and the S&P 500 are overbought and the momentum of the rally is fading, one likely outcome is profit taking the first support at the level of 50-day exponential moving average (EMA) at 815.
2. If resistance at 875 is overcome in the next few days, a sharp short covering rally is possible which would result in a gain of 5% to 7% to the level of 950. We believe that such a rally would be a false breakout and create a good shorting opportunity.
   

Gold and PM Stocks

The latest gold down-leg began in February has now lasted for two months. However, over the past four weeks the price of gold has declined without interruption. Five consecutive declining weeks for the metal is a pretty rare event – this has occurred only three times in the past eight years of this secular bull market (May 2004, June 2006 and August 2008).

In the first two instances, lows in the fifth week were also the lows for that year. Last year, despite a sharp September rebound following the five down-weeks ending in August, we saw the final low only in November. This anomaly is related to the total liquidation of assets by leveraged players during the late 2008 market crash.

The above lets us conclude that the coming week may retest this year’s low (lower $800s), but whether this level is retested or not, a sharp rebound is likely as soon as next week (fifth) or the following (sixth) week. Of course, this assumes that nothing extraordinary occurs this time around.

This is an excerpt from a Resource Stock Guide Newsletter dated April 18, 2009.

Disclosure: No Positions.

Comments

[kelm:]

Three instances of a five week decline in gold and subsequent reversal is not even close to being statistically significant. Physical buying around the world has to pick up and that is not likely unless we get below $850 and stay there for more than a few days or we see solid signs of inflation. I agree that gold looks set to venture into the low $800s and that may represent an important long term low but physical demand needs to pick up for that to act as a springboard to higher prices.

Apr 20 08:56 AM

[conceptwizard:]

Some very good information in this article. Nicely written. We are recieving a lot of mis-information in the media which is causing a surge in the markets. Financials in particular, either the banks are insolvent or their not, which is it? If they are posting record profits and all is well, Why has Giethner allocated 2 trillion to combat an insolvency issue. I don't have confidence in the leadership and the information that is being received.
As the author points out the facts don't support a rally, short selling is taking place, people are responding to media disinformation on Financials which are leading this charge ahead.
The first-quarter 2009 total is the highest quarterly total of completed foreclosures since the foreclosure crisis began. Pre-foreclosure filings – filings that could lead up to a completed foreclosure – also reached their highest quarterly level, topping 600,000 for the first time since the foreclosure crisis began.
The commercial Real Estate Bubble is set to burst within the next few months as well, this will dwarf the size of the housing bubble.
Unemployment numbers are not really 8.6% they are 17% and worsening., this is not a lagging indicator as most people think, it is a leading indicator, and UNEMPLOYMENT numbers DO MATTER!
Now is a good time to realize some gains from the rally we just had, for those who are not comfortable selling short, park your money until this next drop to 500 (or less) of the S&P is over.

Apr 20 09:22 AM

[ArkansasAngie:]

Unemployment is a big deal.

If people don't get jobs, they are not going to increase their spending.

If consumers don't increase their spending then we're in for an extended period of pain.

How long can America afford to pay unemployment benefits to 10% of the population?

How long can Six Flags survive without an increase in consumer spending?

How long can McClatchy survive without an increase in ad revenue?

How long can Hawker Beechcraft stay in business if companies don't buy new airplanes?

How long can Lear get away with not funding its pensions?

I predict the first opportunity for GDP to actually increase is Q4 because then the YoY hurdle will be lessen.

The FEDury isn't expecting a recovery this year. If anything, the FEDury is a bunch of finger crossing optimists.

Apr 20 10:26 AM

[Skeptik:]

Very well written, not to many words but facts.

Apr 20 03:03 PM

[Silk32:]

Great post. I hate to tell you but a group of inner city kids called this recession and the pending financial calamity years ago. We then advised investors in September to get out of the Market and (I) wait until 1Q earnings were announced and (ii) listen for Management's guidance on the future. Yet noone listened. The public has left us no other choice. We have now teamed up with a movie producer to help bring our rigorous investment process to TV. To learn more go to www.newyorkshockexchan.../ . . . Investment ballers aren't born . . . they're made.

Apr 20 03:30 PM

[Old Trader:]

kelm,

I understand what you're saying from a fundemental/macro standpoint, but I would posit that a reversal of this current rally would also help boost the price of gold. Overlaying a chart of GLD over SPY shows a fairly strong negative correlation.

I'll defer to those here more knowledgeable than me on this topic, since I'm really not a "gold bug".


On Apr 20 08:56 AM kelm wrote:

> Three instances of a five week decline in gold and subsequent reversal
> is not even close to being statistically significant. Physical buying
> around the world has to pick up and that is not likely unless we
> get below $850 and stay there for more than a few days or we see
> solid signs of inflation. I agree that gold looks set to venture
> into the low $800s and that may represent an important long term
> low but physical demand needs to pick up for that to act as a springboard
> to higher prices.

Apr 20 11:28 PM