Is This Really Just a 'Junk' Rally?

“Trash is king,” claimed a recent article in the Wall Street Journal, which ran underneath the headline “Can a Rally Last on Diet of Junk?”

Ubiquitously, while GDP plunged 6.1% in the first quarter this year, consumer spending rose 2.2% in the same period.

If trash really is king, then the garbage men were out on the street Wednesday, when that data was released: the Dow Jones Industrial index ended up 168.78 points for the day, at 8,185.73.

Given that news has hardly been optimistic over the last week, with Bank of America (BAC) facing a leadership crisis and swine flu destabilizing overseas markets, the resilience of equities stateside is stunning. Evidently, the Wall Street Journal doesn’t think that’s a situation likely to continue for much longer:

For the quarter ending in June, earnings are now predicted to register a 33.7% drop, compared with a 31.7% decline expected at the start of the month. For the year, earnings are seen dropping 10.6%, compared with expectations for an 8.4% decline on April 1.

Even as financial stocks have bounced, expectations for the group’s earnings have eroded further. The consensus is for financials to post a 45% profit drop in the second quarter, five percentage points more than on April 1.

Wednesday morning, CNBC was trying to make sense of the strength, given the compelling economic indicators to the contrary. The network pointed out that short sellers were being “forced” into the rally as a result of selling strongly into the earnings season on expectations of big declines afterwards. When those declines failed to materialize, the sellers were forced to cover their short positions, prompting an even bigger uplift in share prices.

So is the current rally really just a bunch of rubbish painted in green? Not all think that it is.

“My portfolio is taking off like a bat out of hell, and it’s not just the junk that’s moving. It’s the early cyclical recovery stocks that are moving too,” says Paul Mendelsohn, chief investment strategist at Virginia-based Windham Financial.

Among the companies posting big gains in his portfolio that Mendelsohn considers of high quality are stocks such as Jacobs Engineering (JEC), Apple (AAPL), Peabody Energy (BTU), IBM (IBM), and Frontline (FRO), he says. Mendelsohn adds that his technical indicators point to a longer-term bullish trend, even though he’s uncertain about making any sure-fire predictions given the recent turbulence.

“My gut tells me this is a bear market rally but my indicators tell me this could be more serious,” he says.

But not everyone is so optimistic. Martin Marnick, head of trading at Helmsman Global Trading in Hong Kong, expects bulls to come up short when the realization hits that many of this quarter’s earnings are a “lie.”

“When things get too hard, just make up your own numbers,” writes Marnick in a technical trading report sent to the firm’s hedge funds client Monday. “The FASB decision to relax the mark to market rules just makes it easier to abuse a company’s accounts.”

Marnick writes that a clear sign of earnings uncertainty in the financial sector was the resignation of Charles Bowsher, the former chairman of the Office of Finance for the Federal Home Loan System. The FHLS is the country’s second largest lender after the government. Bowsher resigned in April due to his discomfort with signing off on financial statements on banks using self-assessed valuations for mortgage-backed securities.

But if the rally is part of a longer-term trend, then trash or truffles, that factor alone could help stimulate consumer confidence and the banking system as a whole. Windham’s Mendelsohn points out that the much-hyped government stress tests are a worst-case scenario analysis, which becomes less likely to materialize as share prices go higher. That point is critical because it weakens the case that Citigroup (C) and Bank of America need to raise more capital and thus dilute existing shareholders.

The argument for a sustained uplift in share prices leading to longer-term bullish prospects economically centers around capitalization. If U.S. households begin to witness a rise in the value of their retirement accounts and appetite for riskier assets returns, then two things happen. The first is that consumer confidence starts picking up, as first quarter spending data indicate. The second is that banks start lending to one another more freely, bolstering their balance sheets.

“I certainly think within the banking sector itself that confidence comes into play and the smaller problems banks have are likely to go away [with continued strength in share prices],” says Jim Oberweis, president and lead portfolio manager of Oberweis Asset Management in Lisle, Illinois.

Oberweis says that he isn’t concerned by the market rally, either. “I don’t think that the leadership of companies with fundamental operating problems is likely to persist but it’s not unusual for graveyard diggers to get into the market first,” he says.

Comments

[TeresaE:]

The big banks offered cheap credit (limited time) in Feb, March & April, first time in months that they have done it en masse.

Add to that the destruction of income, including pay & dividends, for a vast number of middle class Americans, which resulted in a lower tax bill, more than likely, a huge refund including the bonuses that are not paid in. I notice that the IRS is announcing their normal, "tax revenues are great" right now.

So, in addition to low interest rates for a few, a huge tax refund for many, of course consumer spending was up.

As soon as the reality of expiring interest rates, partial balances on cards charged up to 30% interest and tax season stops, I get the feeling "consumer confidence" is going to tank to new depths.

Sucker rally is all this is. Study history and what occurred during the beginning of the great depression stretching into the early 30s.

Apr 30 09:07 AM

[TeresaE:]

Correction, I meant that the IRS is NOT announcing their normal, "tax revenues are up".

Oops. Multitasking strikes again.

Apr 30 09:09 AM

[desicon:]

When it is a GDP contraction of 6.1% is good news for stock market? As noted earlier it is a sucker rally. A little uptick in consumer spending cannot be interpreted as sustainable improvement in consumer's financial situation. The consumer fundamentals are:

1) Average debt still high
2) Average asset way down (stocks,home price)
3) Increasing unemployment rate
4) Looming inflation
5) Aging baby boomers no time left to save

At best market is having selective hearing and totally missing the broad negative undercurrent. GM is pretty much dead. How can a company run by UAW and federal government be competitive? Over and above Fannie and Freddie, now AIG and Citi are practically GSE’s. US taxpayers can’t even get any tax write-off ‘s for the trillions of TARP and TALF losses. The depletion of inventory does not mean that there will be new capital investment.

From where I sit the DOW range till 2010 will be 7,000-8,000. Over 8,000 sell, under 7,000 buy.

Apr 30 02:36 PM