Stock Market Moves into Critical Testing Zone

The Dow gained 1.9% and the S&P 500 rose 2.7% last week. Both indexes registered their highest weekly closes since December. The S&P 500 is now only 10% off its October 2007 peak, after registering a 20% peak-to-trough decline twice in the first quarter. Having recovered half of their losses and now bumping up against resistance levels defined by 200-day moving averages, stock indexes have moved into a critical testing zone that will likely answer, over the next few weeks, the question of whether the recent rebound has been merely a bear market rally or the start of a more sustained advance.

Although the stock market has demonstrated impressive resilience given $126 oil prices, we are not ready to embrace the view (which has become the consensus) that the bear market is over. Looking out over the next three to six months, our stock market outlook is neutral at best. When we examine the fundamental, technical and sentiment indicators that are likely to determine stock prices over the next several months, it appears that the negatives outweigh the positives. The stock market has history on its side (in only one of the past 20 Presidential Election Years has the stock market fallen over 2% between May 1st and election day), but this election year has already shown itself to be very different from others.

The fundamentals of the economy - particularly the inflation problem, the pressures on consumer spending, and the de-leveraging process at work following a decade-long credit bubble - are troubling and do not appear to be adequately reflected in stock prices or market psychology. (They are reflected in consumer sentiment, which is registering its worst readings since 1982). The recent recovery in stock prices make sense if the economic downturn is more than halfway complete, and that may turn out to be the case, but it is also quite possible, and we think more likely than not, that the U.S. faces a more significant downturn than we have experienced to date. The leading economic indicators tracked by the Economic Cycle Research Institute do not show the recovery that stock prices seem to be anticipating. According to ECRI "weekly leading index growth remains deep in negative territory, suggesting that the outlook is still recessionary."

On the technical front, the market indices are undoubtedly looking better following the recent eight-week rally, but market breadth has been notably poor. The NYSE advance-decline line, which measures the number of stocks participating in a rally, has not confirmed the recovery from the March lows by moving to a new high. This suggests that it is premature to rule out a bear market rally. The poor breadth and divergent performance of the overall market can be seen in the weak showing of financial and consumer-related stocks alongside the very strong performance of commodity-oriented stocks. Leadership by inflation stocks and weakness by financial and consumer stocks are not the hallmarks of a healthy economic backdrop or new cyclical bull market. In addition to poor breadth, volume has been lackluster in the recent rally. Since the mid-March lows, New York Stock Exchange volume has been consistently below its 50-day average.

Bearish sentiment was an important catalyst behind the rally that commenced two months ago, but the investor sentiment pendulum has swung over to the bullish side and is now a headwind to further stock gains. Recent sentiment survey readings from the American Association of Individual Investors show individual investors the most confident in a market rally since last October. Similarly, the VIX volatility indicator has fallen to the level where rallies since last summer have failed. In the past nine months, the VIX has fluctuated within a range of 16 to 32. The VIX closed last week at 16.47, the lowest level since last October's highs in the stock market. Clearly, the attitude towards systemic risk in the financial markets has changed dramatically since mid-March.

In the very short term (looking out over the next few weeks), the action of the stock market may well be dictated by the price of oil. Stocks could get another push up from a significant correction in the price of oil. Conversely, a further rise in oil prices would likely stop the stock market rally in its tracks. But looking further out, for the reasons outlined above, a cautious approach to the stock market appears warranted.

Comments

[dougnhi:]

Good synopsis. I would counter that lately, commodities and stocks have risen in unison. This is the hallmark of speculation, which can be readily seen in the VIX fear reading, and is evidenced further by the FED's changing of the game to remove all risk from speculation in the market. However, there's a non-zero probability that when oil corrects, the market will correct (or vis-versa). As soon as the animal spirits leave the scene, investors will discover that the FED wasn't as powerful as they thought, and that they're naked and nobody is buying. The clue will be institutional selling. Look for the bear market rally to end soon enough, and the next bear leg to prove that commodities and stocks can (and do) go down together in bear markets.

2008 May 19 09:08 PM

[paulibloom:]

Reading chicken entrails-what amazes me is that you guys really think this analysis is useful-expect the unexpected. Remember the recession that has not arrived. This stuff will keep you poor. By the way most market forecasters are good for one cycle.

2008 May 19 11:40 PM

[Alpha Seeker:]

Boring article. I can read this on Bloomberg. Have more spice.

2008 May 20 01:24 AM

[Hobie Jones:]

Allocate assets among 5 or 6 categories; rebalance no more than twice per year and ignore articles such as this.

2008 May 20 08:17 AM