4 Moves to Make in This Confusing Market

by: Keith Fitz-Gerald

For many investors, the last 12 months have felt like a cross between Dante’s “Ninth Circle of Hell” and Mr. Toad’s Wild Ride.

Even so, after Tuesday’s market action - which saw the Standard & Poor’s 500 Index rebound from a 12-year low to gain 6.4%, and the Dow Jones Industrial Average jump 5.8% - many investors are no doubt wondering if it’s time to pile in.

It could well be. But then again, it just as easily could be a precursor to another financial drubbing - the kind of bear-market “head fake” that I’ve correctly warned investors against on a number of occasions during this financial crisis. Given that perspective, I continue to believe the game we’ve been forced to play as a result of the credit crisis is still far from over.

In short: One day does not a rally make.

And that’s why Tuesday’s almost-euphoric run-up in stock prices seems less like a testament to savvy bailout strategies than it is a revelation of how desperate investors are right now for any glimmer of hope. The notion that a single bank - even if it is Citigroup Inc. (NYSE:C) - could single-handedly cause this kind of an upside rout on a leaked note from its embattled CEO is absurd.

For a true rebound to take place, two things have to change. The first is sentiment. And the second is business conditions. When it comes to igniting a truly sustainable rally, history demonstrates time and again that those two catalysts go hand in hand.

That’s not to say we couldn’t see a rally of 20% or more from here, or that this mini-rally couldn’t last for a while. Bear market rallies have a nasty habit of doing that just long enough to draw in additional investors, only to chew up their money and leave them with big losses when the rally rolls over.

Bear market rallies are actually more common than most people realize and the one we experienced late last year is a great case in point. It started on Nov. 21, and advanced a total of 20% in the subsequent seven weeks. Then it headed south again.

Obviously, I don’t know everything and I expect I’ll hear about it if I’m wrong here. But in a market as unpredictable as this one, and with the insights I wish to share with you, I am less concerned with short-term rallies than I am with long-term investing success. That’s why - if you’re thinking about getting in right now - I urge you to first carefully review both sides of the argument.

Five Reasons Tuesday Could Be a Bear Market Rally

In the “no-way-this-is-real” department:

  • Major institutions - such as Bank of America Corp. (NYSE:BAC), JPMorgan Chase & Co. (NYSE:JPM) and Citigroup, among others - are functionally insolvent. While Citi CEO Vikram Pandit’s leaked note revealing that Citi has achieved two months of profitable operations may conform to generally accepted accounting principles, supposedly so, too, did the trillions of dollars worth of derivatives the banking giant accumulated. Show me $45 billion in government aid and I’ll show you a good time too. Nobody ever went broke on accrual accounting. Show me the cash and perhaps I’ll change my tune.
  • The credit markets remain substantially locked up. According to the U.S. Federal Reserve’s January survey of senior loan officers, 60% percent of domestic banks reported reduced demand for commercial and industrial loans. That’s up fourfold from the October survey, when only 15% of banks reported reduced loan demand. Even now, the banks and players like American International Group Inc. (NYSE:AIG), which have accepted - in some cases, begged for - billions in taxpayer aid, are refusing to detail just where the money went. For now, though, the closely watched London Interbank Offered Rate (LIBOR) is trading at its highest levels since Jan. 8. In case you don’t recall from past columns on the subject, the higher the LIBOR rate that banks charge each other, the tighter credit markets actually are. If you take all of these bits of evidence together, it hardly makes a case for a healthy financial system. In my mind, the real proof would be when financial institutions willingly wean themselves from the central bank’s IV hookup.
  • Hedge funds are still selling. In times of business expansion and real recovery, hedge funds buy like there’s no tomorrow. Yet, for the most part, these stealthy operators are still swamped with redemption requests and a cycle of forced selling to meet them.
  • The sentinels of the U.S. financial system haven’t changed. I have a hard time believing that the same career government officials, regulators and ratings agencies that were asleep at the switch when the financial crisis began, suddenly and miraculously understand how to fix those problems - especially when most of those folks haven’t got a clue about how the financial markets actually work and most of them have never worked in them.
  • Business conditions stink. There are very few companies that have not been materially affected in one way or another by this crisis. Profits are falling and dividends are being cut. Unemployment is rising, personal debt defaults are cascading through the system, and consumer confidence is in the cellar. Sustained recoveries require consumers who actually have money, have jobs and who feel confident.

Four Reasons the Bull Has Awakened From His Slumber

We’ve carefully studied the reason Tuesday’s updraft may be nothing more than a bear-market rally. Now let’s look at the other side. In the “this-might-stick” category:

  • We’re finally experiencing some good news. Pandit’s Citi memo has provided the first real glimpse of hope in months - fancy accounting aside - and could ignite a rush into stocks as investors fear getting left behind. That could turn into a self-fulfilling prophecy, because…
  • Investors have trillions of dollars in cash on the sidelines. According to some studies, there may be as much as $3 trillion to $5 trillion on the sidelines, held by investors who are just aching to get back into the market. It is widely assumed that this money will come roaring in and that it will somehow help the markets recover faster than they would otherwise. (Personally, I have to be honest and say here that I just don’t see it; the estimated $50 trillion that’s been wiped from the face of the planet during this crisis did not go into some magical holding tank. Those losses are permanent. But that’s another story for another time).
  • Technically speaking, the markets were primed for a rebound. And they remain so by many technical measures. As of Tuesday morning, stocks were nearly 35% below their 200-day moving average and we’ve only seen that on two prior occasions: In 1974 and 1982, both of which were followed by serious reversals that presaged important rallies.
  • From a psychological standpoint, the depth of this market decline begs the question: “How much further can it go?History shows that the 1929 crash took approximately 80% off the top while the 2000 crash took approximately 80% off the Nasdaq Composite Index. Now key sectors, such as the financials, for example, have fallen more than 80%. It seems to indicate that we’ve arrived at levels that, in the past, suggested enough is enough and that there may be enough upside to begin nibbling again. Of course, one could argue that the overall markets are only down about 50%, meaning there’s more bloodletting to go. And that’s a valid point. But since we’re really focusing here on the possible catalysts for a rebound and rally, let’s focus on the fact that the risks this time around were largely concentrated in financials, which from a numerical standpoint have been suitably punished. That might just be enough.

Corporate Earnings: The Final Arbiter

Going forward, the biggest issue to watch is corporate earnings. Many investors don’t realize it, but the final quarter of 2008 marked the very first time in history that the S&P 500 reported negative quarterly earnings. So, despite all the catalysts we’ve detailed for you, where we go from here will likely be determined by who earns what and when they earn it.

And just where is “here? ” Even after Tuesday’s manic rise, we’re now sitting just above the market’s 12-year lows. History shows we’ve been here twice before: Once following the Great Crash of 1929, and once in the early 1970s. Both cases turned out to be the kind of phenomenal long-term buying opportunities that I said this financial crisis will turn into once the carnage stops.

What’s important now is to maintain perspective and to really decide if you are a speculator in search of short-term gains that can help you recover your portfolio, or a true “investor” who is seeking long-term gains. If you decide you’re the former, you may be sadly disappointed in the months ahead. But if you’re looking for the latter - and you’re willing to ride out the ups and downs that are certain to come - it’s probable that there’s more potential upside available now that we’re at these 12-year lows than there is still more downside.

Moves to Make Now

As regular readers of Money Morning know very well, I’m an advocate of having a disciplined and well thought-out investment plan that right now ought to incorporate the following elements:

  1. Make a wish list of stocks you want to own. Logically these will include companies with strong cash positions, low or no debt, experienced management and attractive valuations. Obviously, the charts aren’t going to be compelling, but that’s to be expected when hunting for bear market-rally candidates.
  2. Scale in. Don’t bet the farm on an all-or-nothing assumption that “the” bottom has been reached. For some strange reason, most investors are programmed to jump in with both feet when it’s clearly time to just put a toe in the water. We could just as easily see another thousand-point drop from here as we could a similar increase.
  3. Make the markets “prove it.” In order to break the current downward spiral, we’ll need to see a move above 740.61 on the S&P 500 and several closes above that level to demonstrate consistency.
  4. Don’t confuse the desire to make up losses with an actual long-term investing perspective. If you’re anxious to jump the gun and get in, make sure you’re doing so because you’re going after your “A” list of companies - and aren’t merely trying to recoup losses that require you to take on more risk than you’d otherwise be comfortable with. Remember, the reason most people have gotten hurt so badly is that they came into this mess by having too much in stock and, consequently, too much risk. Those investors learned the hard way - and that’s a lesson best not repeated the next time around.

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