Top Five Reasons to Trust This Rally

by: Wall St. Cheat Sheet

By Elliot Turner

Everywhere I turn, people tell me that this rally is not to be trusted. We were hearing that from the first day of September as the market broke its August downtrend, and again Tuesday after the market broke the “important” 1130 level on the S&P. Complaints range from lack of volume, to over-bullishness which I just don’t get. Here are my five most important reasons to legitimately trust this rally:

1. In the long run, the market follows the trajectory of earnings

Whether one believes the market to be efficient or not is irrelevant. Take any subset of time and the above statement is predominantly true. In the latest earnings season, reports were outstanding; however, market prices declined due to concerns out of Europe and of a double-dip. The earnings run-up that carried us through July faded in August, but once again with earnings looming the market is on the rise.

Emerging markets have exhibited particularly impressive results while developed economies took a beating during the Spring and Summer trading sessions. Many US-based companies have significant exposure to earnings growth abroad, and this has provided an outstanding boost to earnings while the US has experienced a speed bump in the road to recovery. This source of earnings growth will continue into the foreseeable future.

Additionally, efficiency gains experienced in the US are not solely the result of cutbacks. There are amazing technological innovations that are changing the way we use, store and process information. These changes have tangible positive impacts for many companies and will free up additional capital for investment in improved production capacity and most importantly, jobs.

2. We priced in a double-dip, but averted the worst

While the rate of growth for the economy slowed during the second and third quarters, we did not in fact dive towards the much-dreaded double dip. Typically in recoveries there is that point in which the robust initial bounce-back gives way to an untimely re-dip in growth rates (this is a must-read from David Altig at the Atlanta Fed on this effect). While that makes for an uncomfortable unemployment picture, the fact remains that our economy is still in recovery mode. Warren Buffett, a man with his pulse on a broad spectrum of American commerce, proclaimed that: “We will not have a double-dip recession at all. I see our businesses coming back almost across the board.”

Buffett’s Berkshire Hathaway (NYSE: BRK.A) owns enterprises in industry, manufacturing, finance and retail among other sectors. He has access to the performance metrics of such a wide swatch of economic activity to the point where he is in better position than just about anyone to see the makings of a double-dip (or lack thereof). The fact that he unequivocally rules out the risk of a double-dip at this point bodes very well for the US stock market in the near future.

3. While volume remains light in the indices, volume in individual stocks on breakouts is impressive

Since this rally began in early September (and throughout the March 2009-April 2010 rally), many market participants complained continuously about the lack of volume. While many look for volume as confirmation in a market move, it is but one indicator out of many that paint a much larger picture. The Reformed Broker put it particularly well in arguing for traders to look at “Price Before Volume.” Additionally, it’s important to remember that people do not panic into markets the same way they panic out. A panic in and of itself generates a whole lot more buying than the ensuing calm after the storm.

Also important to remember is that markets can move up in two primary ways: actively and passively. What I mean by that is we can go up through people actually buying, or we can go up by sellers lifting their offers and asking for higher prices. The latter of these two requires far less volume. This rally started by “wearing out” sellers who had been anticipating a far worse economic landscape than what actually materialized over the last few months. Once we stopped dropping on bad news, there was only one way for price to move – up.

If you look at individual stocks over the last few days, volume has been pretty impressive in our market’s leaders and some substantial moves. Type up some important stocks like Apple (NASDAQ: AAPL), Google (NASDAQ: GOOG) and Oracle (NASDAQ: ORCL) and take note of those substantial and growing green bars over the last few days. That type of volume is clearly people reestablishing long positions in some of our biggest and best companies.

4. Correlation is dying down

Throughout August and early September much of the talk focused on how correlation was incredibly high and stocks were moving in tandem. Along with the dissipation of volume has come the dying down of that correlation. Even while markets were dropping throughout much of the summer, several emerging markets and many individual stocks were exhibiting strength in making 52-week highs. As markets digested with sideways action last week, the rotation of strength from one sector to the next made for a healthy consolidation of the bounce off of the end of August lows.

I wrote about this action on Friday morning after three straight days of overnight down-moves in the futures, followed by the buying of stocks intraday. So long as people take a bottom-up approach to this market (a focus on underlying valuation metrics and earnings growth) then price follows a bullish trajectory. As I mentioned above, over the long run, prices follow earnings growth and this should help suppress the dangerous correlation that saw prices whipsaw back and forth for much of the last 4 months.

5. Many remain underexposed to the long side, despite an uptick in bullish sentiment

A lot of the above factors add up to one key point: many market participants remain underexposed to equities. The volume on the way down is indicative of the fact that many were selling on fears of a double-dip. Since that fear subsided, the lack of volume indicates that many of those sellers have yet to have the opportunity to put their money back to work in this market.

As price continues to make its way higher, along with bullish sentiment, people remain on the sidelines. This does not mean that we will go straight up, but it does mean there should be ample room for people to establish positions on modest pull ins and/or sideways action. Action in individual stocks is your tell. Last week, the biggest tell that the next move would be higher was when Apple, this market’s leader, rallied through the $270 resistance level to close on highs before the weekend. With a stock like Apple trading at a market average P/E ratio, there is ample room for multiple expansion and another leg higher as people seek entries to the long side.

Disclosure: Long GOOG, BRK.B