I like how the market moves up and down in cycles. Usually we have a storyline with a plot, some twists, a climax, and if investors are lucky, a finish higher the previous month that appears to be a happy ending. Consider the following. From March 2008 to 2010 the storyline starting with the March bottom was 1-2% growth in the developed world and 8-12% growth in the emerging markets. Industrials and commodity stocks provided the greatest upside as we all bought into what was tagged the global growth story. Now the initial move up off the bottom also involved government stimulus, some strength in financials, strength in the retail sector particularly at the high-end, and large moves in consumer staples as well. But, to be sure, the narrative, which was symbolized no better than by the weak dollar strong market correlation that often involved commodity and industrial stocks moving higher and emerging markets outperforming European and American ones, forms what appeared to be an official storyline tagged the global growth story.
The U.S. economy grew at a high enough growth rate to fuel emerging market growth rates in the double digits, stimulus money as abound, and the market was led higher but big sectors that made up significant parts of major market indexes like the S&P 500. The story lasted for several years and produced phenomenal gains for many, with the ending eventually a bad one as inflation reached unsustainable levels particularly in the emerging markets, QE2 ended, and the debt crisis in Europe came to the forefront. With these events the powerful original storyline died. The market was no longer the global growth market where large cap stocks with strong balance sheets offered endless growth and impressive dividends. Once that storyline failed when oil topped out at around 115, the fed ended QE2, and China along with other emerging markets shifted from pro-growth to anti-inflationary measures, the bulls attempt to shift the storyline from the global growth story to the technology story where companies not exposed to rising inflation could continue to produce massive profits and earnings growth that suggested all was well in the global economy.
The important point to make in analyzing the leadership that was primarily responsible for the multi-year rally that more doubled the market off its March lows is that the industrial and commodity sectors represent a large part of the S&P 500. Energy alone is around 20% of the S&P 500, and industrials make-up nearly 25-30% of the index. This is why the industrial and commodity stocks provided such strong leadership as they were large enough sectors that the market saw their strong share price movement as representing a reasonably good global economy. Now since the Dow topped out around 1370 when oil topped out at near 115 on the WTI contract, each subsequent relief rally has had a narrower sector or sub-sector of leaders. The first relief rally after the market failed to break out around the 1370 level was by decent but smaller group of industrial stocks but fewer industrial stocks and some commodity stocks, and died at around the same 1370 level. The last relief rally that occurred in June and July took the S&P 500 to nearly 1350, just short of its previous levels reached on recent market rallies and was a move up that involved even narrower leadership.
The reason the latest relief rally in July failed so quickly and at lower levels was in my opinion because the move higher was marked by leadership that too narrow and did not present a compelling narrative for stocks or the overall market that all was well in the U.S. and global economies. Really the only consistently higher stocks during the last rally were Google (GOOG), Apple (AAPL) and IBM (IBM). While these stocks presented a narrative that a part of corporate america remained profitable, these stocks did not present a compelling narrative as to whether or not the U.S. or other parts of the global economy would effectively avoid a recession. Google remains an essential monopoly with 70% of the search market in the U.S., Apple is story in and of itself and not a proxy for overall PC or cell phone demand since they have a near cult following, and IBM seems to operate on multi-decade contracts that essentially make the company function as a defensive stock rather than truly cyclical company. The story being told through the stocks leading the market higher was not compelling enough to test the recent market highs and that is largely why I believe the most recent relief rally failed at lower levels.
Now what is most interesting to me about the recent market decline is that there is now a debate about whether or not we have tested the lows for year since the market has risen nearly 100 points in just the last week alone. Despite quickly dropping from 1350 to nearly 1100 we have no quickly rebounded to nearly 1200 in less than a week. I watched the market move yesterday as the market broke the 1190 level on the sidelines and couldn’t quite decide whether this latest move up was likely to be another failed relief rally or a real and substantive move up with staying power. Two factors jumped out at me. First, volume was anemic even compared to buying interest previous in the year with the market trading around 2 billion shares, and second, the best performing sector that we are suppose to believe will provide the new leadership was utilities. Utilities and agriculture were the only sectors that appeared to be getting real buying since their moves up were on significant volume and were significantly higher moves up than that of most of the indexes.
While other sectors had moves up like energy and the industrials, these sectors moved up on weak volume and energy stocks failed to retrace a significant part of their losses despite oil's impressive comeback from around 77.50 to nearly 87.50. The Nasdaq also performed only decently as Apple seemed to get a decent but not overwhelming bid taking to the high 370s and Google actually dropped precipitously to around 535 (Pretty far from the 620 level the stock hit just a couple weeks ago) as one analyst dropped his target by 100 dollars and downgraded the stock a sell from a buy. IBM was up a couple points but did not appear to be making a substantial move either. Now call me crazy, but I don’t see a utility and agriculture led rally having staying power. Not only are these small sectors that are not proxies for the U.S. and global economies, they present no storyline for the market whatsoever.
To conclude, it’s almost always impossible to say if markets will hit new lows or retest previous highs, but the reality is that even with short-term bonds yielding next to nothing after the fed’s recent decision if capital just selectively allocated to MLP’s, consumer staple stocks, and other smaller sectors, most of the S&P and the overall market should trend lower. If the market is going to make a sustainable move higher I think a storyline with a large sector or group of sectors providing strong leadership will have to lead the way. Utilities and dividend stocks may be great income producers, but these sectors’ share price movements are not going to inspire confidence in markets or the overall economy. While confidence maybe a lagging indicator sometimes, it's hard to currently imagine a market reversing a vicious downtrend without a least the investor confidence that the economy is likely to see moderately better day in the near future.