Is this a Sustainable Bounce or Temporary Stock Market Rally?

Aug.27.07 | About: SPDR S&P (SPY)

Sarah Connor’s lyrics “Get up and move, Don’t make me act a fool, Just bounce” come to mind when reviewing the performance of financial markets since the Fed’s emergency discount rate cut on August 17.

The invariable question is to what extent the actions of the Fed and other central banks have calmed jittery financial markets. A review of the performance of equities, fixed-interest instruments, currencies and commodities over the past six trading days makes for interesting reading.

The chart below tells the story of the rallies that have characterized stock markets since August 17. Global equities in general appreciated by a handsome 4.1%, with emerging markets being the belle of the ball with a rise of 8.2%.

GLOBAL STOCK MARKETS

Source: StockCharts.com

Among fixed-interest instruments the U.S. 3-month T-Bill rate jumped to 4.1%, and bonds were mixed. On the currency front the yen reversed sharply on Thursday and Friday last week, whereas the U.S. dollar resumed its downtrend, and the euro its uptrend.

FIXED-INTEREST AND CURRENCY MARKETS

Commodities gained across the board, with the single exception of energy. The star performer was the agricultural complex (mainly grain and soybeans).

COMMODITIES

Source: StockCharts.com

In evaluating whether one is dealing with a mere stock market bounce or with something of more sustainable proportions, it is important to consider the dramatic reversals of four variables – U.S. T-bill rates, the U.S. Volatility Index (VIX), the U.S. Bullish Percent Index, and the yen – over the past few days. Let’s consider each of these in turn.

U.S. T-bill rates

The 3-month T-bill rate jumped back to more than 4% on Friday, indicating that some of the panic buying of T-Bills has eased. Source: StockCharts.com

U.S. Volatility Index (VIX)

The easing of the credit crisis tensions saw a sharp reversal of almost 50% in the VIX which should allow stock markets to be less erratic. It was clearly positive for equities as a result of the almost mirror-image relationship between the VIX and the Dow Jones Industrial Index shown in the following chart: Source: StockCharts.com

NYSE Bullish Percent Index

The NYSE Bullish Percent Index, indicating the percentage of stocks in uptrends, reversed sharply from a recent low of 31 to Friday’s close of 44. However, in order for the rally to be sustainable the Index will have to breach the 50% mark, at which level half the stocks will be in uptrends.

Source: StockCharts.com

Yen

The graph below depicts the strong inverse relationship between the yen index (blue line), and the Dow Jones World Stock Index (as a proxy for global equities) (black/red line). The sharp decline of the yen over the past few days clearly spurred global stock markets on, allowing the carry trade to live another day.

Source: StockCharts.com

There is no denying that the above factors all add to the positive side of global stock markets’ scoreboards. Furthermore, most equity indices are again above their 200-day moving averages, having come off very oversold levels as illustrated by the chart of the S&P 500 Spyders (NYSEARCA:SPY)below.

Source: StockCharts.com

But, and herein lies the big catch, the rise in prices over the past week happened on very light trading volume. In the absence of stronger volume (i.e. broader participation) I will for the moment reserve judgement on whether we are in fact dealing with anything more than an oversold bounce. I will also be watching my monthly charts very carefully by the end of trading on August 31 to ascertain to what extent stock markets’ primary trends are still intact.