Eric Parnell's  Instablog

Stocks continue to celebrate the survival of the global financial system.  The change in investor sentiment has been dramatic. As recently as early March, the market was deeply troubled that the banking system and the worldwide economy may be grinding to a halt. But in the few months since, this Armageddon view has been swiftly replaced by euphoria that the global financial system will not only survive but may be poised to thrive once again. This dramatic shift in sentiment along with initial signs of stabilization in the global economy and improvement in the credit markets have helped stocks explode +40% higher from the bottom in early March. But while the recent rally has been intoxicating, the investment environment is likely to become more sobering from here with a mounting valuation headwind as a major constraint. 

The stock market rally since early March has been impressive, but only on the surface.  Since the market bottom on March 9, stocks as measured by the S&P 500 have rallied nearly +30% through the end of April.  This has understandably raised hopes that the worst is now behind us and a sustained long-term rally is fully taking hold.  Unfortunately, a closer look suggests that investors are likely to grapple with more downside in the months ahead before the current bear market is finally over.

The length and magnitude of the recent stock advance is typical of a bear market rally.  When the stock market navigates through a major bear phase such as today, it does not move lower in a straight line.  Instead, the broader down trend is characterized by violent corrections followed by sharp rallies.  For example, stocks have endured several episodes over the last century - 1929-32, 1937-42, 1973-74, 2000-02 and today - where the market has declined by –40% or more from its peak.  During these past “great bear market” episodes, the stock market managed to post 17 double-digit bear market rallies that lasted an average of 44 trading days.  Gains during these bear rallies averaged +22% and reached as high as +48%.  But after each of these 17 past instances, the stock market rolled back over to set new lows.  So while today’s rally is promising, the +29% rebound over 36 trading days is still well within the norms of a typical bear market rally.  Putting the current rally in a different perspective - despite its recent strength off of its March 9 lows, the stock market is only back to where it was on January 28.  So while things have certainly improved from recent depths, stocks are still far from out of the woods just yet.