The Stock Market Rebound Is Coming

Includes: DIA, QQQ, SPY, VGK
by: Kevin Flynn, CFA

This may come as a surprise to some who have been following me, but I do believe that it's time to start getting constructive on the stock market. After saying the market would top in October, I've been advising a perch on the sidelines for several weeks now. It doesn't rate to be the worst mistake of your investment career to stay there a bit longer, either. But you should at least be thinking about getting in if you want to capture some upside.

There are several factors favoring a rebound in the near future. To begin with, technical indicators are showing the indices in deeply oversold territory, at least on a short term basis. The relative strength indicator (RSI) on the S&P 500 dipped to 27.7 as of Wednesday's close (below 30 is generally considered very oversold). The Dow is even more oversold, at 25.9, with the Nasdaq and Russell 2000 in the same neighborhood. The Nasdaq is in correction territory, having sold off just over 10% from its September high, and the other indices are close behind.

There's no law about these things. Markets can get more oversold and more overbought at any time. Even so, the Dow Jones RSI is near the low-water mark of around 25 it hit earlier this year during the late May-early June correction, when the S&P 500 hit a low of 23.4. The MACD readings are also near the lows of that period. From the short-term technical point, you should be thinking about where to nibble.

Should the market weaken into the end of the week, it will probably be a result of either the Middle East or the three high-profile industrial reports coming on Thursday and Friday - the New York and Philadelphia regional Fed surveys Thursday morning, followed by the Industrial Production report on Friday morning. Another percent down would leave the markets as oversold on an intermediate basis as they've been since August 2011. That correction consisted of a two-week plunge brought on by the first budget impasse and the S&P downgrade, the latter catching the markets by surprise. One mark of the difference between now and then: gold isn't moving this time.

The biggest feature of the recent move is that market has been caught up in a downdraft of negative sentiment that is political in origin, set off by the re-election of President Obama. While many may feel that this is perfectly justifiable, you might want to keep in mind that elections of Democratic presidents nearly always cause a short-term sell-off, engender predictions of the apocalypse, and provide good buying opportunities after a short wait for the dust to settle. Indeed, much of the selling was set up by a last-minute wave of conviction that candidate Romney was going to close the gap. The resulting disappointment has keened the voices of the doomsday chorus.

Attention was always going to shift to the budget deadline after the election. Had Governor Romney been elected, markets would be rallying on two counts: first to celebrate their Joe getting elected, and second out of a sentiment, right or wrong, that there was no longer any need to worry about the cliff. Obama's election, however, brings the fiscal cliff in as a genuine weapon for the disappointed: We are now doomed. In tone, it resembles very much the blog for the local sports team after a loss to the bitter rival.

It's well to remember at times like this the old trader's maxim that the tape makes the news. Whatever the prevailing wind of the market, the media will look for stories that attempt to justify it. When prices are moving up, bulls get the attention, when they are moving down, it shifts to the bears. The larger the move, the more attention is paid to the outer edges of commentary. As valuations move to extremes, predictions that the Dow is inevitably destined to go three times higher or lower will start to gain currency.

In sum, sentiment has turned so negative that it has now become difficult to surprise to the downside. Marc Faber has been predicting a 20% correction since the spring; now that markets have fallen about 10%, it seems that his latest repetition is showing up everywhere (he also predicted markets could fall 50% after Obama's election, so he is prone to hyperbole).

In the gloomy atmosphere, one thing that isn't repeated was Faber's assessment at the beginning of this week that markets would also bottom out by Thanksgiving ("within ten days") and then rally into year-end: He thinks the big correction isn't this year, but in the future. Faber loves to talk about the end of the decadent West, but he is always ready to make some money trading an oversold market: He bought European equities in June.

It isn't just Marc Faber, either. Dave Rosenberg is starting to turn bullish. Dave Rosenberg. This is a major event, in my opinion, as Dave has always been very, very careful about being constructive on stocks. I have seen similar opinions in recent weeks from other semi-perma-bears.

There is more to it than sentiment, however. Two supportive factors are the consumer and corporate spending. Yes, it's true.

I found the latest round of retail sales data to be more encouraging than I expected. I'm aware that the headline number of (-0.3%) for October was a tenth less than consensus, but since I have learned to live on a diet of raw data with no seasonal adjustment factors, I have been a much happier investor. Understand that I make no accusations of ill intent, but I think the period since the crash has been a bad time for trying to make nice linear regressions. The seasonal adjustments for the October and September sales data make no obvious sense to me, but I feel no need to research the issue. Raw is good. Raw is healthy.

In our case, the discussion uses unadjusted data. The year-over-year sales change in October was 5.3%, compared to the 20-year mean of 4.4% and the median of 5.2%. Ergo, above-average.

Through the first ten months of 2012, retail sales are up 5.6%. The 20-year mean for the first ten months is 4.7%; the median, 5.5%. The increase for August-September sales (combined to smooth out Labor Day and back-to-school) was 4.6%, which is also the 20-year mean. The median is 4.8% (I bring in the median because the period does include two good-sized recessions and recoveries). In short, the October data and the year-to-date data look rather decent to me, especially given that Sandy lightened up auto sales.

This resonates with a good assessment of spending and income patterns by Goldman Sachs (NYSE:GS) economist Jan Hatzius, as brought to you by notable Seeking Alpha contributor Cullen Roche. While the latest market sell-off is probably going to hit sentiment indicators, keep in mind that small business confidence actually improved a bit in its latest iteration, and that employment growth has been remarkably steady this year. It hasn't been robust by any means, but it has been steady and is the best indicator of future spending.

Last Friday brought the latest installment of wholesale sales and inventory data. Again using only unadjusted data, the salient fact is that wholesale sales have been in a weakly ebbing holding pattern since June. The three-month moving average has eased for four consecutive months, and the year-on-year change has gone negative for the first time since the recession. Some may take this as proof of sliding into a new recession, but being more of a cyclical guy (cf. this Bloomberg video with ING), I take this as a sign that ordering has to pick up soon, most likely in the first quarter of 2013.

Last year at this time, corporate America was starting to order up in anticipation of an expiring investment tax credit. This year, they have been looking at an uncertain tax and fiscal picture. It was only natural to put a hold on expansionary spending (especially if you were hoping Romney would get elected and hand out some big cuts and incentives). But in 2013, there's going to be some catch-up corporate investment spending that, along with employment, should help offset the potential drag from a higher tax burden (I don't know what it will be, but my guess is that taxes go down for corporations and up for individuals).

When the S&P 500 was at 1470 in September, I said that earnings weren't good enough. At 1360, they're not so bad anymore. Cisco (NASDAQ:CSCO), NetApp (NASDAQ:NTAP) and Abercrombie & Fitch (NYSE:ANF) all put up decent earnings reports this week. The comments on corporate spending outside of Europe from Cisco CEO John Chalmers were especially encouraging, but the hit from Europe that the big jumbo caps in the S&P reported last month has now been integrated into valuations.

In short, the U.S. economy isn't plunging. It's largely the same economy we've had all year, with the exception that employment is slowly ticking higher. The predictions of escape velocity were off the mark, but so are the predictions of collapse. KKR co-founder George Roberts nailed it on Bloomberg when he said that we're not having an economic recession, but a political one.

So let's examine the political outlook for the rest of 2012. The business news is warning of a bad ending to the fiscal cliff. Public radio is playing dire warnings of a bad ending. Stock prices have fallen nearly 10% from mid-September. Financial advisors go on TV and shriek that you must sell all of your stocks now to avoid paying the 20% capital gains tax in 2013 - 23.8% in the top brackets! Are you kidding me? Cap gains rates went from 20% to 28% in 1986 and stock prices absolutely took off after the end of the year.

There is a difference between public statements that stake out bargaining positions and what has to get done in the end. One, thinking that the EU might dump Greece next week and wreck its economy one month before Christmas is to fundamentally misunderstand Europe. It's different than the U.S. - even in Germany, they'd probably burn Merkel's house down, and she knows it. That's one positive lift next week.

Two, the fiscal cliff is quickly getting to a place where it can only surprise to the upside. Honeywell CEO Dave Cote attended the Obama CEO assembly in Washington, and sounded surprisingly constructive about the possibility of getting something done. Not so much a grand bargain in the space of a few weeks, but a chance for a reasonable blueprint and extension. Treasury Secretary Geithner sounds very much like a man who wants to get something useful done and then get out. His private career will not launch well on the finishing note of chauffering the U.S. off the cliff.

Yes, the President has staked out a bigger revenue number and Speaker Boehner has said no to all tax increases. Those are starting positions. While some have written that it is in the Republican interest not to co-operate, I very much do not see it that way. The Clinton-era government shutdown gave the GOP's image a beating, and both Boehner and the RNC are aware that the public thinks it will be the GOP's fault if we go off the cliff. Exit polls showed that the majority of the public still hold the Bush administration responsible for the weak economy, four years after they left office. It doesn't matter what's fair or unfair, nobody, but nobody, wants the albatross of a cliff accident hung around their political necks. Some deal is more likely to get done than not, and right now prices reflect the opposite.

In conclusion: Europe's problems will not go away next week - but they will not come to a boil this late in the year. The U.S. deficit challenge will not go away this year or the next, but the valuation for a not-worst-case ending for 2012 has become attractive. The real downside support for the S&P 500 remains at 1340. I would be buying everything there - the SPY, the QQQ, the IWM, the VGK and the EEM (I would also hang on to some index puts and buy some oil stocks, just in case Netanyahu goes off the reservation). I couldn't tell you whether or not we will scrape the 1340 area or where, but from here or there the direction of risk has tilted strongly to the upside for the remainder of the year.

Disclosure: I am long SPY, EEM, VGK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am short IWM