Why Last Week's Rally Signals More Trouble Ahead for Stocks

by: Eric Parnell, CFA

It was certainly stirring. After grinding lower for weeks since the beginning of May, stocks staged a stunning comeback last week and made up nearly all recently lost ground. As would be expected, the optimists perked back up on the heels of this suddenly euphoric run, gushing in the media that all is now well and offering up rosy forecasts for the second half of 2011. Admittedly, I’m not so sanguine. Instead, the strength of the rally last week actually signals that more trouble may lie ahead for stocks.

Stocks rallied by +5.6% last week. Putting this into historical context, this was the 29th best week for the stock market out of 3,207 weeks since 1950. Thus, last week’s performance ranked among the top 1% dating back to the middle of last century. Were things really that good last week to cheer the market this dramatically, or was something else at work?

Examining historical weekly stock market performance provides insight on how we can interpret last week’s move. To round things off, I focused my analysis on when the stock market, as measured by the S&P 500 Index, made an absolute move of 5% or more in a given week. Since 1950, stocks have experienced a weekly gain of greater than +5% in 43 instances. Conversely, stocks have sustained a weekly decline of -5% or more 39 times.

The first takeaway – what happened last week has only happened 82 times, or 2.5% of the time, over the past 3,207 weeks. Thus, last week’s performance clearly ranked among the extreme outliers.

So when have these unusually big >5% up or down swings occurred? Most have come during periods of heightened market volatility. For example, over 70% of both up and down weeks have occurred during the secular bear markets from 1966 to 1982 and from 2000 to present.

Within these secular bear markets, nearly all of the violent >5% shifts can be specifically found around the epicenters of extreme market stress. For example, during the height of the oil crisis from 1974 into early 1975, stocks experienced 6 weeks of +5% moves higher matched by 6 weeks of -5% drops. After the bursting of the tech bubble in 2000, the market witnessed 9 weeks of +5% gains and 7 weeks of -5% declines before finally bottoming in 2003. During the peak of the financial crisis in 2008 and early 2009, stocks had 8 instances each of +5% up weeks and -5% down weeks. And during the Post QE1 period from April 2010 to August 2010, stocks tacked on one more +5% week along with two additional -5% weeks.

What about the remaining few stock swings that occurred during secular bull markets? From 1946 to 1966 and 1982 to 2000, nearly all >5% moves were centered on periods of market trauma such as the 1987 crash and the 1998 collapse of Long Term Capital Management. Thus, whether the market is swinging up or down, whether in secular bull market or secular bear market, moves of the magnitude of last week are typically signs of ongoing trauma.

But maybe last week’s rally was one of the rare exceptions? Perhaps, instead of a sign of market turbulence, last week was a strong signal that all is now well and a new sustained rally for stocks is about to get underway? Such conclusions are unlikely for several reasons.

First, let’s dissect exactly what sparked the market rally last week. Stocks rallied +5.6% behind the expectation and subsequent confirmation that Greece, a country that is effectively bankrupt, voted to accept stifling austerity measures in order to receive international government supported emergency rescue funds from the ECB and IMF. In order to make the deal work, credit rating technicalities had to be tortured so that what is effectively a default wouldn’t technically be classified as a default. And even with this help, if Greece can’t effectively implement the crushing austerity measures required to receive the bailout funds, they may end up defaulting in a few months anyway. As an investor in a free market capitalist system, I am certainly not enthusiastic about this outcome. Instead, I am deeply troubled by it.

Let’s take the events of last week down one step further. We faced a situation last Wednesday – in the middle of the market rally mind you - where only 9 members of the Greek parliament had to change their mind and vote the wishes of their near rioting citizens against new austerity measures for the plan to fail and effectively push Greece into full blown bankruptcy. And had the vote failed, global investment markets were likely to be thrown into chaos, as many European banks are not sufficiently capitalized to withstand the blow of a Greece default.

Really? The fate of global financial markets rested in the voting impulses of no more than 9 members of the Greek parliament last week and we could look past this to find euphoria? Are we all to simply overlook the extreme vulnerability that is implied by this circumstance to now just assume that all is well and nothing but clear sailing is ahead for 2011 H2?

While at least some level of residual error exists in even the best investment model, risks like these are particularly unpredictable and worrisome because they are at the mercy of the whims of individuals, many of whom do not directly participate in investment markets. After all, our own U.S. Congress demonstrated back in September 2008 how legislators can sometime chose the “unthinkable” alternative and send markets into a subsequent tailspin. Notably, the coming month's debate on the U.S. debt ceiling will bring this risk back to the fore once again for Congress.

So instead of clear sailing, stocks likely face more challenges in the weeks ahead. Might the rally last a few weeks longer? Sure, or it may fall flat as soon as next week. With lingering uncertainty in Greece along with ongoing problems in Ireland, Portugal, Spain, Italy and Belgium, the problems emanating from the euro zone are far from resolved. On any given day, new problems could bubble to the surface. And with QE2 now over, the U.S. economy showing increasing signs of sluggishness and a vastly overvalued stock market from a long-term average earnings perspective, the headwinds are many for stocks in the months ahead.

Fortunately, investment markets offer a variety of non-stock alternatives in the current environment that provide attractive opportunities going forward. These include Gold (NYSEARCA:GLD), Investment Grade Corporate Bonds (NYSEARCA:LQD), Non-Financial Preferred Stocks (ATT, ALM, FGE, XCJ, DRU) and selected high quality stocks in the food, household products, tobacco and utilities industries. Even U.S. Treasuries (IEI, IEF, TLT) offer appeal on a short-term basis, more so now following the drubbing endured last week during the stock rally.

The key is to remain nimble, as last week’s rally is not likely anywhere close to the end of the unexpected twists and turns for stocks or investment markets.

Disclosure: I am long GLD, LQD, ALM, FGE, XCJ, DRU, IEI, IEF, TLT.

Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.