4 Reasons Why the Recent Stock Bounce May Be Short Lived

Includes: DIA, QQQ, SPY
by: Eric Parnell, CFA

Stocks are showing some signs of life in recent days. After an -18% cascade lower on the S&P 500 since mid July, stocks thrashed back and forth for a few days last week. But by last Friday, stocks finally broke higher and looked to carry this strength into the current week with more gains on Monday.

While this turn has been refreshing following a stretch where stocks fell 10 out of 11 days on the S&P 500, the recent stock bounce may be short lived. The following are four reasons why:

1. Stocks Had Become Vastly Oversold

From a technical perspective, stocks had simply fallen too far, too fast. Having -18% of stock market value wiped out over the course of twelve trading days is an exceptionally dramatic move, as it would have been reasonable to expect that at least some investors would have had a fundamental reason to step in either with new long positions or to at least cover short positions along the way.

Of course, these are the consequences that can stagger a market that until recently was artificially inflated by unprecedented monetary stimulus (QE2) and is still struggling with financial institutions that are forced to liquidate assets in order to survive. But to put the recent correction into perspective, the following is the Relative Strength Index for the S&P 500 Index during recent severe market corrections. Any reading below 30 indicates a market that is oversold and may be due for a bounce. The lower the reading, the more oversold the market.

  • 22.88 - October 10, 2008
  • 26.92 – March 3, 2009 (RSI was 28.47 at the bottom on March 6, 2009)
  • 16.46 – August 8, 2011

In other words, the stock market was more oversold last Monday than it was during the worst of the early days of the financial crisis by a wide margin. Thus, we were long overdue for any kind of bounce in stocks.

2. Treasury Yields Have Hardly Budged From Near Historical Lows

Investors flocked to the safety of U.S. Treasuries during the recent rally in much the same way that they did during the depths of the financial crisis in late 2008. In mid-December 2008, 10-year Treasury yields fell as low as 2.04%, and in recent days they reached 2.09%. And the recent rally in Treasuries has occurred despite all of the handwringing over the U.S. credit rating downgrade. If we were seeing a true sense of sustainable relief in the stock market, we would have likely seen a more profound rise in yields as investors migrated out of Treasuries and back into equities. But instead, Treasury yields have settled into a range between 2.20% and 2.35% that suggests that a good deal of concern is still underlying the market.

3. Economic Data Continues to Get Worse

In recent months, the “good” economic data has been bad, and the bad economic data has been downright ugly. While the market was allegedly celebrating an unexpected decline in weekly jobless claims to 395,000, the fact of the matter is that such a reading along with the recent monthly employment figures are far too tepid to support any meaningful economic recovery.

And one has to look no further than the latest economic readings on Monday to see a global economy that is increasingly sliding toward a double-dip recession. The latest Empire State Manufacturing Index reading was a -7.7, which came in well below expectations and marked the third straight monthly negative reading. And the NAHB Housing Market Index came in unchanged at 15, which indicates that homebuilder confidence in the outlook remains at depressed levels.

These are just the latest in a long line of bleak to deteriorating economic reports and are not the types of readings that are supportive of a stock market that is still overvalued from a long-term historical earnings perspective even after the recent sharp correction.

4. Latest Meeting of European Leaders May Disappoint Expectations

Some of the hopeful expectations surrounding the latest debt crisis summit between German Chancellor Merkel and French President Sarkozy in Paris have been surprising to say the least. First, previous meetings have produced little if any resolution to the crisis thus far, so nothing much sustainable should be expected coming out of this latest session.

In addition, the idea that European governments will all of the sudden acquiesce around the idea of greater fiscal unity when it has been met with resistance thus far seems implausible. If anything, the situation is becoming more strained and fractured, not more unified, as even the healthiest countries in the region are increasingly seeing the challenging fiscal realities that lie ahead.

Also, while the idea of a eurobond sounds great to throw around in casual conversation, it is riddled with flaws from an application standpoint. More specifically, a good deal of the financial burden from any eurobond program would fall on the back of the Germans, and the resistance is likely to be strong to take on much more than they already have.

Perhaps this latest summit will provide the dramatic solution that the market seems to be hoping for, but we’ve seen this story play out too many times already in the last few months with the same lackluster outcome. And even when EU leaders try to roll out the bazooka, it ends up misfiring anyway. Thus, I remain skeptical that this latest meeting will provide the elixir the market is apparently hoping for.

Bottom Line: While the recent bounce in the stock market has been a refreshing development, many indicators suggest that the rally is likely to be fleeting. Stocks were dramatically oversold, so any kind of bounce was long overdue and may continue for the next several days. But the bond market is not signaling any conviction in the stock rally. And until we see a pick up in economic activity or the beginnings of a clear resolution to the situation in Europe, we’re likely to see stocks remain under considerable pressure going forward.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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