The Trouble With Last Week's Stock Market Rally

by: Eric Parnell, CFA

The stock market just wrapped up a tremendous week. Unfortunately, this is not necessarily a good sign for stocks looking forward. While it's possible that last week will mark the beginning of a new sustained rally in stocks, history suggests otherwise.

It was just five trading days ago, that investors were heading into the post Thanksgiving holiday weekend with stock market losses heavily on the mind. And for good reason, as stocks were in the process of cascading lower and the crisis in Europe appeared to be careening out of control. But as discussed in a recent article heading into last week, the potential existed at any moment for policy makers to intervene with extraordinary measures. And intervene they did with a major globally coordinated policy effort. In the wake of this effort just a mere five trading days later, stocks are rejoicing and bullishly ebullient commentary has quickly returned to the airwaves.

A Great Week, But a Bad Sign

Stocks had lost -9% in the three weeks leading up to the Thanksgiving holiday. This was a bad sign. Stocks gained over +7% in the past week following the Thanksgiving holiday. This is equally a bad sign.

Why? Because extreme market moves, whether they are to the upside or to the downside, are signs of ongoing instability. Such violent market swings rarely occur in stable markets, as investors demonstrate greater confidence in their allocations and carry out decisions in a more fundamentally driven and deliberate fashion. But when the environment becomes unstable like today, investors are increasingly at the mercy to quickly respond to a market held hostage by dubious rumors and schizophrenic price movements. Such instability undermines investor confidence. And while many may proclaim that today's valuations may seem cheap on the surface, this loss of confidence may cause stocks to look vastly more expensive, as investors become far less willing to pay for each dollar of earnings in a stock market that seemingly makes no sense from day to day.

What Does History Tell Us About Last Week's Rally?

So what can we take away from the recent rally? The stock market posted a +7.39% return for the past week, which represents the 31st best weekly performance since 1928. It should be noted that of the 30 instances when the stock market posted a better weekly performance, all 30 occurred during past or current secular bear markets (1929-1945, 1966-1982, 2000-Present). In other words, rallies of this magnitude or greater have always occurred during periods of persistent instability.

Dissecting these past 30 instances further is informative in determining what we might expect in the coming weeks. Before moving further, it is worthwhile to extract those past instances that do not correlate with the current environment. For example, 8 occurred at or around major market bottoms following extended sharp declines (1932, 1974, 1982, 2003 and 2009). We are not at a major market bottom today. Instead, we remain in the middle of an extended trading range. Thus, the trends coming out of these past 8 instances do not apply. One other larger bounce came in the week following 9/11, which was an extraordinary and unique set of circumstances that also do not have applicability today.

This leaves us with 21 past instances that have comparability to the past week. In 16 of the past 21 instances, or 76% of the time, stocks went on to give up these robust weekly gains and more in a matter of 2.5 weeks on average. Applying this to the current situation if the same outcome were to play out today, this would imply stocks that ended the week at 1244 on the S&P 500 would slide back below 1158 by the week leading up to Christmas. Now given that stocks have posted gains 76% of the time during the month of December dating back to 1928, it would not be a surprise to see stocks hold their gains a few weeks longer than average if this surrender scenario were to play out again this time around.

Of course, stocks managed to keep moving sustainably to the upside in 5 past instances, or 24% of the time. So what do we need to see for stocks this time around to rank among these selected few and to further this move to the upside instead of sliding back lower in the next few weeks?

The key remains the situation in Europe. And a critical development on this front is set for the coming days. A summit of European Union leaders is scheduled for Friday, December 9. Many investors are expecting at least some meaningful progress toward a resolution to the sovereign debt crisis that continues to plague the region coming out of this meeting. Actual, real progress on this front (and not more ambiguities or vaguely defined programs, but real tangible solutions) would go along way to bolstering investor confidence that we are finally taking the needed steps to begin working toward putting the crisis behind us. It will take time. It may even take years. But if investors have the sense that things are finally moving in the right direction, this may be enough to support the rally to sustain itself beyond the near-term.

Another influence that could lead to a more sustainable rally in stocks is the implementation of another round of aggressive monetary stimulus from policy makers. This would include the launch (or indications of the pending launch) of QE3 by the Fed. If the past week confirmed anything, it was the continued overwhelming responsiveness by investment markets to monetary stimulus of any kind. Like a sugar high, it’s not sustainable, but it provides the global economy more time to resolve its underlying problems with some stock market euphoria along the way.

But if the situation in Europe takes a renewed turn for the worse, or if policy makers do not deliver another policy fix as expected, or if some other unforeseen event shocks global markets, then the recent rally will be relegated to the fate that befell the other 16 past rallies that also quickly surrendered its gains.

So what is an investor to do facing such persistent market volatility and uncertainty to help mitigate the risk? First, adjusting portfolios so that stocks do not make up a proportionally large percentage of an overall portfolio allocation is a good start. And emphasizing more defensive high quality stocks such as PepsiCo (NYSE:PEP), HJ Heinz (HNZ) and Clorox (NYSE:CLX) within this stock allocation can also help smooth volatility associated with this stock allocation. Beyond stocks, many asset classes are turning in consistently solid performance with much lower volatility and a low correlation to stocks in the current environment. These include U.S. Treasury Inflation Protected Securities (NYSEARCA:TIP), Agency MBS (NYSEARCA:MBB) and Utilities Preferred Stocks (XCJ, DRU, SCU, ELA). Others asset classes offer robust returns potential such as gold (GLD, IAU, PHYS) and Silver (NYSEARCA:SLV), with gold in particular moving independently from stocks. And if a full blown crisis were to break out, an allocation to U.S. Treasuries (IEF, TLT) may also make sense, although a consolidation of recent gains in this category would be a plus from a risk control perspective.

It promises to be another interesting week ahead for stocks and investment markets. An eventful path to the end of the year to be sure.

Disclosure: I am long PEP, HNZ, CLX, TIP, MBB, XCJ, DRU, SCU, ELA, GLD, SLV.

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.