Why I Still Think This Rally Is Sustainable

Today's article comes courtesy of frequent contributor Dave Van Knapp. His site, SensibleStocks.com, is chock full of clear-headed ways to pick stocks and explains the oft-unappreciated role of dividends.

The blogosphere is full of pundits trashing the current stock market rally. I wrote an article several weeks ago making a case for the sustainability of the rally, and I got flamed by commenters. Sentiment ran about 10-1 against me.

The day that article ran, the S&P 500 finished at 884. It closed Monday at 943, up 7%. Altogether, the current rally, which began on March 10, is now almost three months old. During it, the S&P 500 has risen from 677 to 943, a 39% increase. The climb started fast, then slowed somewhat but has still kept going generally up. Each month since the rally began, the S&P 500 has gone up: 9% in March, 9% in April, and 5% in May. The largest drawdown during the run has been 5%. I have been investing into the rally via a series of purchases of SPY (SPDRS, an ETF that tracks the S&P 500), using tight 8% trailing sell-stops. None of the stops has been hit. All positions are in positive territory.

So is the rally sustainable, or is it a "sucker's rally," a "dead cat bounce," an unsustainable secondary bullish period within a primary bear-market?

By one measure, a definition used by Ned Davis Research, it already is a bull market. They declare a bull market occurs whenever there is a 30% rise in the stock market over a 50-calendar-day period. That's already happened.

The same organization uses an alternative definition of a bull market: a 13% rise after 155 calendar days. That has not happened yet. It has been 84 days since the rally began on March 10. But note that the increase required by the second definition is just 13%. The market could go backward from here (to 765) and still satisfy the second definition. But we're interested in future sustainability. So for purposes of discussion, I arbitrarily tacked on the second definition to the first to arrive at a definition of "sustained" from the time of the first article. The bottom line: Will the S&P 500 reach 1050 by October 12, 2009? That would certainly be a sustained, investable rally in most people's minds. It would comprise a total increase of 55% since the March 9 low and a total duration of about seven months.

I think this is possible, perhaps even better than a 50-50 chance. Those who guffawed a few weeks ago have already witnessed the market achieve almost half of the additional rise needed. At 943 today, the market is less than 12% short of the 1050 target, with more than four months to get there. Will it?

There are plenty of articulate, intelligent commentators making the case that the market is heading for a major fall, and soon. But there are arguments to be made on the other side. Here are the ones I consider to be the strongest:

• Bull markets usually begin during, not after, recessions. In talking about the market, I am emphatically not talking about the economy. The economy is staggering, with more shocks still to come. Unemployment will undoubtedly rise, perhaps to 10% or more. But unemployment has always been a lagging indicator. Charts of the last nine recessions (available here) show clearly that eight of them had bull markets begin prior to the end of the recession, about six months on average.
• There are signs that we may be nearing the end of the recession. If bull markets start a few months before recessions end, the question becomes, are we nearing the end of the recession? There is evidence pointing in both directions, but here I am making the case for the sustainability of the rally, so I'll focus on positive signs:
  • The Institute for Supply Management monthly survey of new orders bottomed in December, with a positive trend since then.
  • Initial unemployment claims appear to have flattened out, even as the total number of unemployed still rises.
  • We are seeing stable and rising commodity prices, with oil up more than 40% from its low and copper up more than 50%, both indicative of improved demand.
  • There are some positive signs in the still-bleak housing sector: The inventory of unsold single-family homes peaked last summer at 4.5 million units and has subsequently declined to 3.7 million. (A more typical inventory level is 2 million units.) Affordability (the ratio of median house payments to median income) is improving, and the $8,000 first-time-homebuyer tax credit is beginning to impact the market, at least at the low end.
  • The University of Michigan Consumer Sentiment Index, which fell to a low of 55.3 in November 2008, rose in March to 57.3, in April to 65.1, and in May to 68.7. The indicator has now been up five of the last six months.
  • Bernanke and the Federal Reserve are pulling out all stops to stimulate the economy. Since September 2008, the money supply (M2) has been growing at a 13% rate, one of the highest in the post-World War II period.
  • Measures of banks' willingness to lend each other money have shown substantial improvement. The rate premiums demanded for unsecured lending between banks fell by more than 80% from their 2008 peak to mid-May. In the past couple months, several banks have successfully floated secondary stock offerings, raising capital to get out from under TARP restrictions and/or to strengthen their capital positions.
  • The Index of Leading Economic indicators rose in May for the first time in seven months.
• Post-recession rallies can be powerful. According to Navellier and Associates, the five most recent recessions before the current one (all shown in the previous charts) each spawned powerful rallies. Working backwards in time:
  • Recession: March, 2001 to November, 2001. Market bottomed in October, 2002, then gained 50% in 17 months. (Note: This is the only one of the bull markets that did not begin during the recession.)
  • Recession: July, 1990 to March, 1991. Market bottomed in October, 1990, then gained 45% in 19 months.
  • Recession: July, 1981 to November, 1982. Market bottomed in August, 1982, then rallied 66% in 15 months.
  • Recession: January, 1980 to July, 1980. Market bottomed in March, 1980, then went up 35% in 12 months.
  • Recession: November, 1973 to March, 1975. Market bottomed in October, 1974, then gained 76% in 21 months.

To repeat, the strongest argument that this rally is sustainable is the historical pattern that bull markets start about 6 months before the end of recessions, backed up by growing evidence that the current recession is in its final months.

Anybody who claims to know whether this is a bear-market rally or the end of the bear market is blowing smoke. Nobody knows at the time it is happening. What I've tried to do here is make the best case for the sustainability of the rally in the face of a continuing bad economy. The jury -- the investing public -- will make the final call.

Disclosure: Long SPY, IBM, and FDS, having moved from an all-cash position at the beginning of March to about 52% invested now. If the market continues to go up, I will continue to buy into the rally.

Comments

[pstrusi:]

Good luck

Jun 02 11:41 AM

[Larry House:]

It might be sustainable--then again, it might not. Caution is called for.

Jun 02 12:04 PM

[Maxe Paul:]

"Anybody who claims to know whether this is a bear-market rally or the end of the bear market is blowing smoke."

Well i will just go on record now and say, that this is a bear market rally, im not claiming it, im stating it.

I wont even bother trying to justify why this is, because some people just would not, or do not want to understand.

You either get or you don't.

Jun 02 12:08 PM

[thiazole:]

Name a recession that didn't have government stimulus...

While I agree that this stimulus is poorly spent money, the point of stimulus isn't as crutches but as a jump start. Companies stopped producing and people stopped buying. If people buy again, companies will have to produce again. It is that simple. The inventories really are much smaller than many here would pretend. It doesn't take much to force companies to start producing again.


On Jun 02 09:17 AM uphill-skater wrote:

> My only problem is that this whole thing is totally due to the government's
> stimulus package. There will come a time when these crutches will
> be removed. Hopefully by then the economy has not become so reliant
> on this intervention that it suffers from huge withdrawal symptoms.
>
>
> There is a big difference between training wheels and life support...
> right now I can't tell which one we're on...

Jun 02 12:21 PM

[Davewmart:]

The idea that this rally is sustainable depends upon the thesis that this is a liquidity crisis, not a solvency crisis.
Debt remains at historic levels, and where is the recovery in the real economy to come from?
Just as 'liar loans' were at the heart of the housing crisis, this is a 'liar recovery', as the banks were given carte blanche to fiddle their figures, in Goldman Sachs case simply loosing an inconvenient month.
The Fed also has hidden how it is using it's printed money, but it has gone to GS to game the market - for some of the signs of this obvious manipulation, read Tyler Durden at Zero Hedge and on this site.
The stock market rally is one more bubble - what has fundamentally improved in the economy?
Bubbles pop, and this one will as soon as enough sucker money has been extracted - the bank executives are selling their shares into the rally.

Jun 02 12:26 PM

[Fighting Yoda:]

The credit bubble economy is finished, time to cleanup and pay the debts. The stimulus and PR and the hype will only last so long.

Jun 02 12:30 PM

[Dave Wrixon:]

What you haven't understood is that really is different this time. Most of your arguments bear no relevance to todays situation. Indeed, the fact that we live in a post-globalisation period mean that the metrics have totally changed so comparisons with past recession is to a large extent meaningless.

The bottom line is that there is no significant capital investment going into the economy.

The only thing that has signficantly improved company results is the return to Mark to Myth Accounting. That is not going to provide a basis for a sustainable recovery.

As for the the increase in prices of raw materials, that only indicates that they are being hoovered up by China, which will return zero benefit to the US economy. Indeed, higher oil prices are likely to kill any recovery that there might be stone dead.

Good Luck! You are going to need it.

Jun 02 12:51 PM

[Moon Kil Woong:]

It's only sustainable because trillions are trying to escape long term treasuries and possibly even short term treasuries. For any rise in stocks there must be a corresponding fall in the value of the dollar and/or a rise in inflation and bond yields. Party it up now, but I doubt the hangover will be worth it.

Jun 02 01:18 PM

[conceptwizard:]

I once bought a skunk, thought it was a cat, turned out I found out it was a skunk.

The moral: careful what you buy it might blow stink on you.

Jun 02 01:24 PM

[user396040:]

We are in uncharted waters. We have never had a debt crisis of this magnitude; we have never had such an expansive policy on the part of the FED. It is very difficult to predict how these things will net out.
On the other hand, there are certain bets that can be made. Several months ago, the high yield market was so depressed that it reflected an assemption that there would be a greater rate of defaults than during the Great Depression. At that point in time, one could make the assumption that - either high yield bonds were a good investment or we would all go back to living in caves and conducting transaction through barter. High yield bonds have since experienced a massive recovery. At this point, I think a reasonably safe bet can be placed on recession resistant, dividend paying stocks(PM, T, PG, MCD, KO, JNJ). Some of these companies have demonstrated their ability to continue generating profits in this atmosphere and have strong balance sheets to support continued and increasing dividend payments.

Jun 02 01:59 PM

[cash:]

There is a good bit of manipulation going on in the market. Market level is all about perception, and that perception has been completely turned since 6th March. Run with the big boys and take cover until other big boys force a U-turn. The ROI on detailed analytical thesis (that Tyler Durden often provides) has been minimal lately. Not worth it.

Jun 02 03:11 PM

[Tomcat101:]

Team Obama is trying to turn chicken shit into chicken salad. It might look good, but it's still just chicken shit. Don't eat it.

Jun 02 04:16 PM

[uphill-skater:]

Not really refuting whether government stimulus is warranted or not. I agree that Intervention/ Stimulus is needed to smooth the extremes of boom-bust cycles.

I'm refuting the speed of this rally. What I suspect is that the free money banks are getting is getting ploughed into leveraged bets rather than conventional loans. And this is accelerating the bid in stocks & commodities.

Keep hearing about how all these banks are having $100 million trading days on their prop books. They figure that the fastest way to get yourself out of a hole is to borrow from the taxpayer and bet everything on black.


On Jun 02 12:21 PM thiazole wrote:

> Name a recession that didn't have government stimulus...
>
> While I agree that this stimulus is poorly spent money, the point
> of stimulus isn't as crutches but as a jump start. Companies stopped
> producing and people stopped buying. If people buy again, companies
> will have to produce again. It is that simple. The inventories really
> are much smaller than many here would pretend. It doesn't take much
> to force companies to start producing again.

Jun 02 04:40 PM

[mrmillergd:]

"To repeat, the strongest argument that this rally is sustainable is the historical pattern that bull markets start about 6 months before the end of recessions, backed up by growing evidence that the current recession is in its final months."

I'm so tired of this old, worn-out saw.

Furthermore, some evidence of a recession in its final months does not mean that it is so. There is a far larger preponderance of evidence that suggests the economy will keep contracting for at least another year. Some good news does not make for an automatic turnaround in GDP growth.

Jun 02 04:51 PM

[David Van K...:]

This is from Dave Van Knapp, author of the article.

Thanks, everyone, for your "good luck's", even though I know you are being sarcastic.

I hear and understand all of your reasons for the unsustaibability of the rally. But practically all of them go to the bad shape the economy is in. My article is about the market, not the economy.

Are they inextricably linked? Of course, over the long term. But over the short term, it is obvious that the market can go up while the economy is struggling, or only propped up by government spending. It is happening right now...is that not undeniable? Look at any chart of the S&P, Dow, or NASDAQ since early March. It's right there in black and white. The market's been ging up while the economy is in recession.

How long do you require a rally to last before you will call it "sustained"? One month? Three months? Five months? One year? Five years? I submit that the answer to that question is personal to you, and that it depends on whether the rally lasts long enough for you to profit from it. Day traders and swing traders and trend players have already profited from this rally, which is about 3 months old. Hopefully, everyone is protecting their profits with sell stops, as I am.

Maxe, I do get it. I clearly stated my parameters. What are yours? You said it's not worth getting into. I think it is, and I invite you to state your definition of a "bear market rally." I am not suggesting that this rally will go on forever. No bull market does. But anyone can widen the time frame of any bear market or bull market and demonstrate that it was embedded within a longer trend of the opposite direction. So what? The question is whether it was investable, for you, within the parameters of your investing strategies.

Dave Wrixon, of course it is different this time. Every bear market and bull market is different. They all have their own unique reasons for happening. That does not mean that a pattern that has repeated itself over and over--of bull markets starting while a recession was still going on--may not happen again.

Mrmillergd, I am sorry that you are tired of hearing that same old saw. Your weariness does not mean that it won't happen again, or that it is not happening right now. You are right that my list of good news items about the economy does not guarantee that the recession is in its final months. I stated that explicitly. On the other hand, your negative data points don't mean that the economy is not recovering, either. I stated that "there is evidence pointing in both directions." The data is mixed, and neither of us really knows at this point.

Profiting from even a short-term rally (say less than one year long) does not mean that things have to end badly for an individual investor. Protect your profits with sell-stops, enjoy the ride while it lasts, and be ready to hop off when it stops.

Jun 02 07:39 PM

[Billw77:]

Dave,

You are correct that this market can go up further. But anyone with a brain knows that that is not good option. The reason being that the fundamentals are terrible and sometime in the third quarter we are going to see a major correction. The correction will not affect traders like yourself, but it will wipe out trillions more of real wealth that has been invested by average Americans for retirement. Definitely not a good thing. We instead need to go ahead and suck it up and clean up our debt situation. Throwing all of this money at the problem is just going to prolong the issue and make it cost more to resolve it.

Jun 02 11:10 PM

[David Van K...:]

Bill,

I'm normally not a trader, I'm a long slooow dividend guy (see my website). But I'm not ignorant of price, and I find this rally interesting, especially the visceral reactions to it. I'm trying to think logically about it, and I am certainly interested in making some money from it if I can. That's the thrust of my articles and comment.

As to what's good for America, I agree totally. I wrote a little-noticed article, "Addicted to Debt," (available here: seekingalpha.com/artic... ) last September about the mess America got itself into by becoming greedy, sloppy, and debt-ridden. I don't know whether the solutions being tried (including government money and involvement) are going to work out good or bad (I am cautiously optimistic), but I do think that long-term, America has to change its ways. I am glad to see the savings rate going up, people using stimulus money to pay down debt, the elimination of too-easy credit (especially mortgages), and banks building up capital. Only in these ways can we build a strong foundation for future growth. I'm a fan of de-leveraging (as it's called), and I am personally averse to debt.

Jun 03 09:40 AM

[Maxe Paul:]

David, i always put my money where my mouth is, if you read my comments going back i predicted the current bottom of 666 in the S&P, at which point i predicted a multi month rally, naturaly i loaded up.

I would like to add that NOBODY predicted the current March bottom (despite what those dopes on CNBC are now claiming), i was the ONLY person! Now i also predicted a multi month rally to around 1000 in the S&P, which we are almost there.

I predicted the October low was not the bottom, the November low was not the bottom, and im also predicting the March low is not THE bottom.

Now at some stage i admit i will be wrong, but who are you most likely to believe, somebody like Cramer who is wrong ALL the time or someone who is right ALL the time, so far?

Although i am not going to reveal my market timing secrets here on SA, i will say i do A LOT of research daily, weekly and monthly to make sure i am at one with the market. All evidence both technicaly and fundamentaly, plus numurous outlier events, point to this being a bear market rally, nothing less and nothing more.

And i would also like to add that traditional "bull market" signs and crossovers mean nothing in a bear market such as this one, just because we may technicaly become a bull market dose not mean it will be one, (note 1929 crash for this as evidence).

When a market crashes to the extent that this one has, any bear rally will move further to the upside in balance to the dramatic downside effects.

So to sum up my argument, i have laid the facts out with what i see as the market going forward, and i fully agree that this has been a sustainable rally, no argument there, but at some stage the market will again be overpriced given the "new reality" we are trading and living in, when this occurs, and the economy further deteriorates we will sell off to new lows again overshooting, and hopefully find a REAL sustainable bottom going forward........see you there!

Jun 03 02:48 PM

[swaps:]

We are no where near the end of this recession. We may be at a plateau which will support current employment levels for a while. But there is no job recovery in site. But that's okay. A year from discouraged workers will stop job hunting and the government will declare unemployment had dropped to 5 percent.

Manwhile, the recent Congressinal hearing - not today's with Bernanke but the one with the blonde woman who could not answer questions until studies were done - reported the Fed could not say where the money went.

Maybe some of it is being used to ramp up stock prices to elitist insiders can sell shares to the plunge protection team. Insider selling is running at 6 to 1 some observers are claiming.

Jun 03 11:10 PM

[uphill-skater:]

You can't be serious right? Let's say even if you were right ALL the time. How about showing a little humility.

Looks like you want want some attention.... so here goes...

Yes ..Yes.. You're the beeesst... You're awwesome .. Nobody can call the markets like yoou caann ... They should put up monuments in your name ...



On Jun 03 02:48 PM maxe wrote:

> David, i always put my money where my mouth is, if you read my comments
> going back i predicted the current bottom of 666 in the S&P,
> at which point i predicted a multi month rally, naturaly i loaded
> up.
>
> I would like to add that NOBODY predicted the current March bottom
> (despite what those dopes on CNBC are now claiming), i was the ONLY
> person! Now i also predicted a multi month rally to around 1000 in
> the S&P, which we are almost there.
>
> I predicted the October low was not the bottom, the November low
> was not the bottom, and im also predicting the March low is not THE
> bottom.
>
> Now at some stage i admit i will be wrong, but who are you most likely
> to believe, somebody like Cramer who is wrong ALL the time or someone
> who is right ALL the time, so far?
>
> Although i am not going to reveal my market timing secrets here on
> SA, i will say i do A LOT of research daily, weekly and monthly to
> make sure i am at one with the market. All evidence both technicaly
> and fundamentaly, plus numurous outlier events, point to this being
> a bear market rally, nothing less and nothing more.
>
> And i would also like to add that traditional "bull market" signs
> and crossovers mean nothing in a bear market such as this one, just
> because we may technicaly become a bull market dose not mean it will
> be one, (note 1929 crash for this as evidence).
>
> When a market crashes to the extent that this one has, any bear rally
> will move further to the upside in balance to the dramatic downside
> effects.
>
> So to sum up my argument, i have laid the facts out with what i see
> as the market going forward, and i fully agree that this has been
> a sustainable rally, no argument there, but at some stage the market
> will again be overpriced given the "new reality" we are trading and
> living in, when this occurs, and the economy further deteriorates
> we will sell off to new lows again overshooting, and hopefully find
> a REAL sustainable bottom going forward........see you there!

Jun 05 01:24 PM