The Rally Could Be Here... For Now

The next rally may be here.

Over the last month, I’ve warned countless times of a pullback in the financial markets. However, even I didn’t expect the brutality of the recent rout— between Thursday June 5 and Tuesday June 10, the S&P 500 plunged 5%.

In the short-term, the market is dramatically oversold. And we could well see the S&P 500 rally to 1375 to test its 55-day moving average [DMA]. However, if the S&P 500 can’t break above this level, we’re in for more trouble.

As you can see, traders have been using the 55-DMA (red line) as a critical level for determining the market’s next major move. Significant moves about the 55-DMA have preceded sustained rallies as traders piled in. Similarly, significant moves below the 55-DMA have resulted in gut-wrenching plunges.

Given the market’s oversold status, I was expecting we’d see a strong rally Monday or Tuesday of this week. The fact that we didn’t doesn’t bode well for stocks. And if the S&P 500 can’t get above the 55-DMA and stay there soon, watch out.

There are a number of factors at work here. For one thing, we are in the midst of earnings season, which is always crapshoot. However, for this particular crapshoot the stakes are higher than usual.

Financial firms, which lead the market both up and down, fudged most of their 1Q08 earnings through various accounting ploys. The most common examples were claiming profits from marking down their debt and altering their reported results between earnings announcements and publishing their 10Qs—Lehman Brothers (LEH) has recently come under fire for this practice.

To be sure, we’ve had a rocky first half of the year. But overall the market is only down 7%, which is not terrible given the state of affairs for corporate America. Consider the following… according to Bloomberg, if you removed the $70 billion earned by oil producers in the last two quarters, profits at companies in the Standard & Poor’s 500 Index tumbled 26 percent and 30.2 percent, the biggest decreases for any quarter since Bloomberg started compiling data in 1998.

In spite of this, analysts expect S&P 500 earnings to grow 8% this year and a whopping 23% next year. That’s some pretty spectacular growth, especially given the massive drops in profitability of the last two quarters.

In simple terms, hopes remain high despite a truly horrific first half of 2008.

Right now, all eyes on are earnings. If 2Q08 results disappoint, the market is heading downward. And if the US recession proves deeper and longer than Wall Street expects, we’re in for a really ugly second half of 2008.

So while I think we may see a brief rally in the short-term, things are not looking good for the fall. I’d use whatever rally emerges in the coming weeks to close out speculative positions and establish some shorts.

Comments

[gabe borenstein]

The stock market right now is not about 55 days DMI .I would not be too negative on the economy and the stock market.The failry agressive easing that we have seen since the last year ,still did not have the full impact on the economy(monetary lag,9-12 months).The fiscal accomodation(rebates) allowing for the multiplier of seven,will prove out to be a very relevant stimulus(again,allow for the lag).For all of the talk about recession ,statistically we are not there .In fact the weaker dollar (J-curve) will likely to assist economic momentum.For all of the current weakness,U.S is still the global economic locomotive. Our cerrent weakness will lead to the economic implosion in the emerging markets(extremely leveraged)leading to a major flight into to dollar denominated assets(U.S),leading to unprecedented stock market rally in the second half of the year ,if for the wrong reasons.

[jayz]

ditto 100%

[zenalgorithm]

How do you explain the VIX moving slowly up?

Financials won't rally until 2009, neither will the market. The investment banks are going to be heavily, heavily regulated now - so you won't see them rally huge.

This will be the most volatile year most of us have ever seen.

[alphameister]

As Cramer likes to say, "There is always a bull market somewhere." Does anyone doubt that the bull market in the energy sector is well underway with a lot of room to run? It won't be immune if the more vulnerable sectors tumble to new lows, but it is the place to be for those seeking a bull market.