If Things Are So Bad, Why Is The Market Going Up?

by: James A. Kostohryz

Markets don’t go up by 15% or down by 15% without any reason or cause. One may not agree with those reasons. But there are reasons.

I am bearish on in a medium term time frame due to my concerns regarding the viability of the plan recently announced in Europe to prevent systemic economic and financial contagion. In this particular case, my timeframe for the current European plan to unravel is six months.

In the shorter term – say the next six weeks – I believe that the market can continue to rise. On balance, I think the market should sustain a positive bias. The following are some of the factors that have been pushing stocks (SPY, DIA, QQQ) up and which may continue to support a rally in the next six weeks:

1. Portfolio rebalancing by managers protecting their jobs. The consensus on Europe has been overwhelmingly bearish. Hedge funds that were short are being forced to cover. Mutual funds that were underweight equities need to rebalance their portfolios to more closely track their benchmarks. Fund managers are afraid of unemployment in this kind of market. Thus, even if their views are bearish, they will not risk getting fired for underperformance. It can take weeks for this rebalancing to reach equilibrium.

2. Fed meeting. Some market participants have been speculating on a Fed announcement on November 2 of QE directed at further support for the mortgage/housing market.

3. G-20 summit. Heads of state don’t get together to talk markets down. Great efforts will be made at this summit on November 3-4 to talk markets up by announcing or hinting at measures to support Europe.

4. Follow-up policy actions in Europe. Many details of the plan announced on October 27 are still not clear. European leaders will try to put a market-friendly spin on the aspects of the plan that are still being worked out.

5. U.S. growth seems resilient. The 2.5% GDP growth in the third quarter is above “escape velocity.” Data for September showed a bounce in growth relative to August. Furthermore, I expect relatively resilient data reported in November corresponding to the month of October. Much of this pickup in growth is due to temporary factors related to a relieving of pent-up demand caused by the sentiment shocks in late July and the month of August. However, whether it is temporary or not will not be relevant to the market in the short term. The market is not in a skeptical mode. Market participants are most skeptical near the bottom. After a swift run-up of over 15%, market participants are now in a self-justificatory mode – i.e. they are looking for any evidence that will relieve their anxiety about buying into the rally.

6. Super-committee. Expectations surrounding the super committee have been so low that it will be difficult to disappoint on the downside. I believe that an upside surprise is far more likely. If the committee comes up with more than $2 trillion in deficit reduction, I believe that the market will receive this quite well.

In sum, the market is rising strongly in the first instance because the consensus was so bearish that the decompression effect has been large. Second, a variety of short-term fundamental factors have supported and will probably continue to support this upward bias driven by portfolio rebalancing.

In this context, the major U.S. indices including the S&P 500 (^GSPC), Dow (^DJIA) and Nasdaq (^IXIC) could extend the current rally substantially. For example, the S&P 500 could easily retrace back to the 1,340 area where the current decline commenced, or even make an assault on the 12-month high of 1,371.

Short-term traders may be able to take advantage of this situation, although event risk is currently very high for any long or short equity position.

Longer term investors will best be served to take positions in strong companies such as Apple (NASDAQ:AAPL), Intel (NASDAQ:INTC) and Microsoft (NASDAQ:MSFT) at lower levels that will probably become available when the blatant weaknesses of the most recent European plan to shore up PIIGS finances are exposed. The key variable to monitor in this regard are the sovereign bond yields in Europe. If PIIGS bond yields are not brought down - and consistently kept down - below 5% in the next month, or if sovereign yields spike above 6.7%, all bets are off for the global equity relief rally.

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