Ready for Range Trading?

The market appears to have topped on an interim basis after a sharp reversal this week, slightly but briefly exceeding the top-end (920) of what I had expected. The S&P 500 fell short of its 2009 high set in early January.

What lies ahead? Another free-fall? A quick reversal and resumption of "the new bull market"? No, after a year of free-fall with meek rallies that couldn't get us to a zero return on a three-month rolling basis until late April, we are now set for "normal" markets after our first real bear market rally. As you can see in the chart below (click to enlarge), if the current level of the S&P 500 (883) holds up over the next few weeks, the 3 month move will be pretty much off the charts. Even if not, it will be exceptionally high:

So, we will have moved from the absolute worst 3 month performance to one of the best over the past 40 years in a course of 3 months. What a rally indeed!

I began this year with a view that Q2 would be the first up quarter since Q3-2007. With the quarter 1/2 over now, it seems likely to be the case (as long as we hold 798 roughly, though dividends gives us a very small cushion). In that forecast, I also predicted that we would make new lows late in the year and hopefully end the bear market. You can review the whole analysis, but here is an excerpt:

My base case for stocks is that they decline about 15-20% this year (S&P 500 of about 720-765). This level should serve as a multiple of about 12X-13X S&P 500 earnings I expect now for 2010. I expect an interim low in late March to mid-April, a positive Q2, a low in late Q3/early Q4 (call it 625-675) and maybe a positive Q4 overall. I believe that the biggest story in stocks this year will be the large losses in some of the largest names, like GE, T, WMT, and the large banks. Unlike Q4, where stock-pickers had very little chance, I expect that we will at least have a shot this year despite the negative overall tone. 20-30% of stocks in the Russell 3000 could actually rise this year despite the overall pressure on the broad market.

At this point, it is clear that my timing for that first bottom was slightly off (and a bit lower than I had initially anticipated) and that the ultimate low may have already been made. I expect the rest of the year to track my original forecast to some degree in terms of where we end up ( lower than here), but I don't think that we necessarily make a new low. We could end up "testing" the old one - God help us if we fail! For now, though, I expect to see a range trade of 800-900 on the S&P 500. Here is a chart of the last two years (click to enlarge):

A pure chartist may be salivating over what looks like a potential "inverse head and shoulders" pattern if we were to drop to 750 or so, and that may turn out later to be the case rather than a deeper test towards the old lows. For now though, I think we do some work in that 800-900 area as we battle for a positive Q2. What keeps us from rallying?

• Equity issuance (see my article last week)
• Continued dividend reductions
• Realization that we are plateauing, not accelerating

What keeps us from crashing back down? I don't have a lot of bullet points here, but I do believe that the market has adjusted to the capital crunch better and understands that not every stock needs to be puked out. I believe that the armageddon scenario that encouraged so many professional investors to raise cash to unprecedented levels is off the table, and they will continue to be buyers on dips. Later in the fall, the lows will probably tie into a realization that 2010 isn't likely to offer much of a recovery. I am sticking to my prediction that the bear market ends then (even if March proves to be the ultimate low). The rest of the year should be a trader's market.

I want to conclude with with a very long-term perspective: Stocks are highly correlated to GDP. In the chart above, the bottom panel indicates real GDP, which is falling (not so rare). What is rare is that nominal GDP (the actual GDP, not inflation-adjusted) is falling, which creates quite a problem. We need GDP growth to fix our leverage issues that exist at the personal, corporate and government levels. In the past 60 years, the S&P 500 (before dividends) has almost precisely tracked the nominal GDP, growing 7% vs. 6.9% on a compounded basis (click to enlarge):

If you look closely at the bottom two panels (click on chart above), you will find, not surprisingly, stocks lead GDP. The GDP decline over the past year of -0.5% doesn't seem extreme enough to justify a post-Depression worst annual decline of 47% in the S&P 500 until one realized that the number is going to be a lot worse. In Q3-2008, we produced at a $14.4 trillion annual rate. If one assumes that the current level just reported for Q1 holds over the next two quarters (not likely to be that good), we would have a post-WWII low of -2.5%. The reality is that it is more likely to be closer to a nominal decline of 4%, truly off-the-charts.

I continue to recommend that investors stick to good balance sheets. Companies with bad balance sheets will be cutting dividends, selling stock, enduring higher costs of maintaining their debt and spending too much time worrying about financials rather than trying to preserve or grow their businesses. That has been what I have been saying for quite some time, so nothing new there but a sense of urgency now that the rally appears to have ended. I would also suggest that this might be a good time to write covered-calls.

Disclosure: No stocks mentioned