Unsustainable Rally and Valuations - Is a Correction Coming?

by: Promod Radhakrishnan

A look at how some of the retail picks from my last blog performed clearly indicates the rally that this sector has seen in the past month or so.

Wal-Mart (NYSE:WMT) from 52.90 to 55.34; March 52.5 options - from 1.4 to 2.9

JCP from 24.89 to 31.42; March 26.0 options from 0.7 to 5.4.

ROST from 46.43 to 54.07; March 45 options - from 2.2 to 8.8.

KIRK from 16.67 to 20.07; March 17.5 options - from 0.5 to 2.5.

Though some of the above are longer-term value plays too, I believe the sector in general has seen too much of a rally considering how fundamentals driving the sector have moved - (un)employment levels, wages, and consumer confidence as a leading indicator. The same probably applies from a broader market perspective too - we have seen a steep rally from early year lows and the DJIA has already touched close to 10,800, a massive rebound from the 6500 levels touched at its worst point. Fundamental indicators on the other hand have yet to show sustained improvement:

  • Job losses have significantly decreased from the 300K per month levels 6 months back to sub-100K per month levels; however that's only arresting the decline and not really driving positive growth
  • Manufacturing & supply side indices have not budged a lot over the past 6 months - the ISM PMI index for example has only inched up from 52.5 levels 6 months back to around 56. More importantly, there has been some deterioration over the past 2 months
  • Housing market inventory remain reasonably high at 7-8 months of sales nationally and hasn't budged from that level for the past 6-9 months. This is despite continuation of the tax credit in to 2010.
  • Personal consumption expenditure has improved, but consumer confidence indices are not showing sustained improvement
  • Bank lending/credit has still not improved significantly over the past 6 months

Having said that about the US market, Emerging Market stocks have seen an even larger share of action, leading to valuations close to unsustainable levels - especially considering the risks associated with price bubbles (China), inflation (India), commodity prices/demand (Brazil, Russia) etc. Friday's move by the Indian central bank to raise repo and reverse repo rates shows clearly that rate tightening and hence tempering of growth can be expected over the next 12 months. Analysts in fact predict an over 200 basis point increase in bank rates in India over this period.

Considering this backdrop at this point in the economic cycle, there probably is more down side than upside from a short-term (3 month) perspective. Except for financial sector stocks, there could be little positive news over and above what has been factored into the recent rally. Prudence would demand pruning investments in Emerging Market picks, retail, real estate holding companies to name a few - all of which are slated for a correction.

Having said that, there still are some medium and large-cap picks in technology (ADBE is an interesting pick) , Consumer staples (GIS, CPB, DLM etc), Financials (like C) can continue to deliver, but except for staples, it's safer to wait than to jump in yet.

Disclosure: None