Stocks Are Due for Consolidation, But the Worst Is Behind Us

The stock market has enjoyed its sharpest six-week rally since 1938, surging 28% from March 9th through last Friday. The financial sector – up an impressive 79% over this period – has led the advance, as fears of systemic failure have abated. To put the recent surge in financial stocks in perspective, the sector is still down over 10% year-to-date, which reflects how severe the carnage was in the first two months of the year, and how a large percentage gains are mathematically achievable from the very small base that financial stocks were reduced to six weeks ago.

Investors are now pondering whether the recent rebound in the stock market is the start of a new cyclical bull market, or merely a “dead cat bounce” like the six-week rally we had from late November to early January. Stocks are clearly very stretched in the short term, and due for a period of correction and consolidation, but evidence is accumulating that a major bottom was made in early March.

The economy and the financial sector have stabilized following the crisis environment that predominated for a full six months in the wake of the collapse of Wall Street finance last September.

The Economic Cycle Research Institute’s leading economic indicators have improved to the degree that ECRI has asserted that the worst of the downturn is behind us and a business cycle upturn could be underway by the end of the year. Technically, the recent move in the market has been much stronger than the rally that occurred late in the fourth quarter of 2008. Breadth, which measures the degree of participation across various sectors of the market, has been very impressive. Indicators of upside versus downside volume suggest that the selling pressure largely exhausted itself early last month, and that buyers are re-emerging and beginning to deploy some of the huge amount of cash that has built up on the sidelines.

Lastly, the longer-term sentiment backdrop remains constructive; although the bullish camp is gaining more adherents, there is still ample skepticism for risk assets to climb the “wall of worry,” which is so typical in a new bull phase.

While it appears likely that an important low was made in early March, the stock market finished last week in an extremely overbought condition. Nearly 90% of the stocks in the S&P 500 closed above their 50-day moving average on April 17, which is the highest reading of the past two years (see Chart 1). This suggests that the short-term uptrend is at or near completion, and that stocks are due for a period of consolidation of the recent thrust off the low.

Chart 1. While Stocks are Overbought on a Short Term Basis...

Accordingly, investors should be cautious about committing new capital to stocks right at this juncture. A decline of 5-10% would be very typical of a market that has traveled so far so fast , even off of what could well turn out to be a major bottom. Such a correction would afford a more attractive entry point for investors seeking to increase their exposure to stocks to participate in the next phase of the rally. Chart 2 serves as a reminder that despite a strong initial rally from the March 9 low, stocks remain near the bottom of their ten-year range. From its present level, the S&P 500 could return 10% annualized for the next six years and still not regain its 2007 and 2000 peaks.

Chart 2. They Certainly are not on a Longer Term Basis

Comments

[mrmillergd:]

I've yet to see a longer term bull thesis on SA that describes why the fundamentals support a market rebound.

Apr 21 07:26 AM

[Robert DiAl...:]

I think you might be right, that we may have seen the bottom. Although, we will still see some chop along the way.

Apr 21 08:19 AM

[doubleguns:]

We came within inches of another great depression and yet everyone wants this to be just another run of the mil recession. We may still collapse into a depression but it looks less likely. I just do not believe we get this close to the edge and then V bottom out like some run of the mill recession. This will be known at the least as the "great recession" once we get out of it but the entire world is in this mess. Therefore depression still seems possible.

We have a long way to go yet and we may not have even hit bottom. The govt money everyone says is helping seems to be keeping the viscerated on life support pumping blood into them yet they have not been stitched up. AIG may need MORE money.

Better that you walk very carefully here because the house of cards could be taken down by something so insignificant somewhere in the world no one sees coming. Some bank, some govt default, some currency crisis and the cards fall. Extream caution is needed here and as a gold bug I sincerly believe 10-20% gold is a requirement but thats just my feverish opinion of the yellow stuff.

This rally is not an answer to everyones prayers it could be bouncing along the bottom or it could be the begining of a nightmare.

It absolutly does not mean the worst is over. IMHO

Apr 21 08:38 AM

[Fabien Hug:]

10% a year for 6 years? Never with the current economic situation, leverage is gone. For now.

Apr 21 08:39 AM

[sieraromero:]

We did hit a major bottom recently. Of that there is no doubt. however, that does not mean that we will not hit other lower bottoms in the near future. The market is being artifically propped up by massive government stimulas, relaxing accounting rules, and other forms of smoke and mirrors. This cannot last especially since the gop is trying to kill future stimulas to the economy. The talking heads on cnbc are telling the masses now is the time to get into the market as a long term investor. Ofcourse they are right however, it is going to be a very, very, very long term investment to be made whole or profitable. Good Luck to you all!

Apr 21 08:54 AM

[Alphameister:]

Very sound perspectives. It isn't necessary to posit a strong economic recovery in order to expect average annual returns of 10% or more from the market's March lows. The rebound since those lows has already provided about three years worth of those returns. A market that had discounted economic Armageddon can double in price merely because the center held when most expected it wouldn't.

Apr 21 10:04 AM

[MGA_1:]

It's not over - we're in a lull right now between stages of real estate defaults. Next up is commercial real estate then alt-a/option arm. Defaults should start picking back up around summer, autumn of this year. There is also a tremendous amount of housing in default that the banks are not putting on the mls for fear of having to write down the loans (and put themselves into default).

I hate to say it, but we have a long ways to go with this one.

Apr 21 10:49 AM

[Allan Frain:]

The first graph could have been used to call several bottoms.

The second graph looks like a classic double-top.

Try again.

Apr 21 11:21 AM

[MWRjr:]

It is good to see so many pessimists out there commenting. The bull market we are now in needs a "wall of worry" to climb. When all the pessimists throw in the towel and admit that they missed the bottom and start to invest (probably not for another 6 months or 2000 points up on the Dow) it will then be time to sell and take profits.

Apr 21 12:54 PM

[jambo:]

Hmmmm....unhuh, SHORT!

Apr 21 06:33 PM

[jambo:]

MWRjr
That's a real fine strategy if your about 16. There will be plenty of time to recover after learning the massive error of ways.

Apr 21 06:36 PM

[Francisco M...:]

Bottom line? There is none.... The government's new job description - United States PR Agency. Every piece of news gets twisted to sound good enough to please the market expectations. It is my opinion that these strategies are borderline illegal but hey, it's the government.....they can do as they please, i.e. Geithner not paying his damn taxes.

Apr 21 07:23 PM

[Old Trader:]

I was really looking forward to the earnings numbers coming out, in hopes that they'd provide a bit of cheer, but so far, I've not been "impressed". It seems that the vast majority of the "beat consensus" numbers have fallen into one of two categories; either dubious accounting and "one time" gains from the financials, and effective "cost cutting" measures from the non-financials, which bumped up margins. Neither of those categories are "sustainable", and most guidance has not been overly promising, either (there HAVE been a few exceptions, of course, but only a few).

Apr 21 08:29 PM