What Is the Underlying Logic to this Rally?

Includes: FAZ, SDS, SRS
by: Raymond Micaletti

We have just witnessed one of the most intense market rallies in history (if not the most intense). Since the March 6th intraday low, the S&P 500 has risen 30% in 30 trading days, has been up six weeks in a row, and has not had three consecutive down days during that span. Unsurprisingly, 89% of the stocks in the S&P 500 are now trading above their 50-day moving average.

On a short-term basis, then, it’s hardly controversial to say that, at current levels, the market is unambiguously overbought. Given its impishly deviant nature, the market—conveniently—reached this overbought status right in the neighborhood of significant overhead resistance (the 870-to-875 zone on the S&P 500). The notable thing here is that if the market fails to clear this resistance on its first few attempts—while overbought—hardly anyone would view such a failure as an incrimination of the rally (because failure is expected, at first). Such a failure at resistance, should it materialize, most likely would not dissuade investors from adding to or initiating long positions once the market has undergone a temporary pullback that clears it of its overbought status.

But will the market pull back in the near-term? Despite being non-trivially overbought (which is normally reason enough for the index to take a multi-day breather), there are several reasons why the market may in fact continue its upward march unimpeded.

One reason the market may not pull back immediately is because the combination of overhead resistance and overbought status has most market professionals expecting a temporary pullback—which those same professionals will then be using as an opportunity to add to existing long positions or to initiate new ones. That is, the playbook emerging from market commentators is this: expect temporary market weakness and then after a 5%-10% pullback, begin positioning for the market to resume its uptrend. The problem here is that if too many people are reading from the same script and leaning too heavily in one direction, the market is apt to assert its independence and jujitsu this majority.

We seem to recall a similar playbook from the fall/winter of 2008/2009, when the market had risen off its 740 low to the mid-800s—at that time the expectation was that the market would continue to rise to 1000 over the course of the spring before retesting its 740 low later on in the year (and many people were boldly calling 740 the bottom). Instead, the market topped out around 875-900 and made a beeline for 666. Thus, the fact that too many people are expecting (or is that hoping for?) a short-term pullback—and advertising that they will be using that pullback as a buying opportunity—ought to make shorts nervous.

A second reason the market may confound the short-term bears has to do with the ongoing pain in the quantitative asset management space, as reported here, here, and here. This pain is forcing quants to unwind short positions—which apparently have been concentrated in the stocks and sectors that have performed the best during the current rally (financials, consumer discretionary, low-priced stocks, low-quality stocks, negative momentum stocks, etc.). As a result, any time the market has dipped over the past two weeks, it has been met by buyers, who most likely fall into one of the two following categories:

  • Quants, who, at this point, appear desperate to cover short positions at any price.
  • Wall Street sharks who, sensing blood in the water, are trying to front-run the quants, knowing that those quants will be actively buying any short-term dips.

Because this dynamic may have not completely played itself out yet, we may be gearing up to witness a market squeeze of epic proportions.

A third, more pedestrian, reason the market may not give in to expectations of a short-term decline is because, believe it or not, the current rally has not been all that extreme when one considers its underlying logical structure in conjunction with the shifting macroeconomic and sentiment landscapes.

Now, we concede that such a statement is bound to be viewed as controversial—after all, quants have just piled up major losses that would attest otherwise, and bears have been growling that the rally has been driven by low-quality, low-priced stocks that have had no business doubling or tripling in a mere six weeks. Moreover, didn’t this article begin with the acknowledgement that the current rally has been one of the most intense in market history? Indeed, it did. Allow us, then, to present our case for why the current rally, when viewed in the proper context, has not been that extreme and why its underlying structure has made perfect sense (in an almost elegant way).

First, the qualitative case: If one looks at a chart of the S&P 500, one will notice that we are essentially at the same level we were at on February 9, one day before Treasury Secretary Timothy Geithner unveiled his much-anticipated, yet severely-lacking-in-details bank rescue “plan.” The then-ambiguity of Geithner’s plan disappointed investors and was the catalyst that sent the market into its February-to-March tailspin.

Let’s further note that if the market had been approximately fairly-valued in the 800-934 region in which it bounced around for two and half months prior to February 10 while the economic data was falling off a cliff and there was no visibility as to what the administration’s plan was for the banks, then it’s certainly not extreme for the market to be back in the middle of that range when the economic data is, arguably, getting less bad (the “second derivative” argument) and we now know that the administration is doggedly determined not to wipe out the shareholders or bondholders of the too-big-to-fail banks. (As an aside, we personally think the “second derivative” argument is a tad silly, but for a market looking for anything to grasp onto, it was there in a pinch.)

In essence, it’s as though on February 10 market participants collectively became scared that the world was, well, going to end. And the market action over the remainder of February further reinforced that belief as the selling pressure continued, unabated.

But as more and more economic data started to come in less bad than expected…as various government officials started to give perceptibly more upbeat commentary on the economy…as big-bank CEOs gave word that their firms had made money in January and February…as Congress put enough pressure on FASB to cause it to loosen its mark-to-market rules…and as the Fed finally played the quantitative easing card, market participants naturally started to reconsider their apocalyptic worldview. As a result, between March 9 and today, we’ve essentially rewound the tape to the status quo ante—which we would argue is not unreasonable in light of our current information set.

So far our case has been qualitative, but a quantitative case can be made, as well, that backs up the notion that the market has essentially erased the February 9 – March 9 selloff. To make this quantitative case, we computed the returns for each stock in the S&P 500 over the February 9 – March 9 period, ranked the stocks by these returns, and then grouped the stocks into deciles. The following chart shows the average return for each decile during the February 9 – March 9 period:

That is, the lowest decile of stocks had an average return of -53% during the February 9 – March 9 period, while the highest decile of stocks had an average return of -2%.

Next, we were interested in how these same groups of stocks have performed during the rally:

In the above chart, as in the preceding one, the blue columns represent the average returns of each of the deciles determined by the February 9 – March 9 selloff. The orange columns represent the average returns of each of those same deciles during the entire rally, while the red columns represent the average returns during the initial stage of the rally and the green columns represent the average returns during the latter stage of the rally. As one can see, on average, the more (less) stocks fell during the preceding selloff, the more (less) they have gained at each stage of this rally.

We also find that, for the most part, there is a relationship between how much stocks sold off in February and how much they had sold off in the preceding year:

In the above chart, the blue columns are as before—the decile returns during the February 9 – March 9 selloff—while the red columns are those same deciles’ returns over the preceding year. As we can see, for the most part, the more stocks sold off this February, the more they had already sold off during the preceding year.

Not only have the returns during the rally been related to how much stocks had fallen during February, they have also been strongly related to stocks’ forward earnings yields (based on analysts’ estimates for next year’s earnings as of March 9):

The above scatter plot shows this relationship between rally returns and forward earnings yields (the forward earnings yields were computed within the same deciles determined by the February 9 – March 9 ranked returns). While the relationship is not perfectly linear, it appears to be a strong relationship, nevertheless.

Lastly, despite what seems like the enormity of this rally, the average stock is now only about 3%-5% higher than it was on February 9:

The above chart shows the average returns from February 9 – April 17 for each of the same deciles as before (defined by the February 9 – March 9 selloff). As one can see, stocks in the 9th and 10th deciles have done fairly well over the full selloff-to-rally cycle (stocks in the 10th decile—i.e., the ones that fell the least during the selloff—are up 22% since February 9), but stocks in the 1st through 8th deciles are only 1% to 5% higher. The average stock across all deciles is 5% higher now than on February 9. Excluding the 10th decile, the average stock is only 3% higher.

To summarize, on average:

  1. The more a stock fell during the selloff, the more it has risen during the rally.
  2. The more a stock fell during the selloff, the more it had already sold off in the prior year.
  3. The higher a stock’s forward earnings yield as of March 9, the higher its return has been during the subsequent rally.
  4. Despite the historic rally, stocks, on average, are only 3%-5% higher now than they were on February 9.

In other words, the market, with a fairly stunning degree of underlying structure, has essentially reset itself to its pre-Geithner-bank-plan-announcement level. In light of the marginally less dire circumstances investors perceive the world to be in, this strikes us as completely reasonable—even if it required that some stocks exhibit triple-digit returns during this rally in order to reclaim their pre-selloff levels. Which is another way of saying the prior selloff was most likely overdone. In resetting itself to pre-selloff levels, the market has thus borne out the logic: if things are seemingly less bad now than they were prior to the selloff, the market should be at, around, or slightly higher than its pre-selloff level.

While we think there are compelling reasons (listed above) that the market can defy expectations and continue to rally, there are also several reasons to be cautious. First and foremost, the market is overbought and also in a long-term downtrend, the combination of the two is typically a low-risk entry point to establish short positions.

Need a second reason for caution? Beware the ascending wedge on the S&P 500:

The folk wisdom attached to ascending wedges is that they are typically bearish patterns because the steepness of the lower uptrend line is ultimately unsustainable. As one can see from the chart, we are more or less at the apex of the wedge (i.e., we have to exit the wedge relatively soon, either on the upside or the downside). Further, the thinking goes, that when an asset breaks downward from an ascending wedge, it is projected to fall by the distance between the highest peak and the lowest trough in the wedge, which in the S&P’s case is approximately 115 points. Since a break of the lower trendline (if it were to happen in the next day or two) would occur at roughly the 855 level, the projected downside would be—surprise, surprise—740, a level of major support for the index.

Lastly, one thing that gives us pause, and which really is the fundamental issue in whether this rally is sustainable or not, is that analysts’ estimates for next year’s earnings are fairly aggressive, and very much detached from the trailing 12-month earnings. The average stock appears to have a P/E of about 10 or 11 based on analysts’ estimates of next year’s earnings. What’s more, the earnings estimates as of April 17 are lower than they were on February 9 (meaning the estimates were exceedingly aggressive then), and have been sequentially lowered while stocks have been rallying.

We think it’s safe to say that if those earnings estimates turn out to be correct, the market will likely continue to rally throughout the year and will exceed 1000 with little problem. But given how much of a gap there is between the actual earnings of the past twelve months and the estimates for the next twelve months, we think it’s likely that earnings disappoint and the rally stalls (eventually), setting up the market to retest its low at some point later this year.

So how are we positioned? We happen to be short the market, short financials, and short real estate, though we wish we had done the preceding analysis before establishing those positions (which were established based on the prevailing overbought conditions in an ongoing bear market)!

But, as they say, you pays your money and you takes your chances.

Disclosure: Author is long SDS, FAZ, and SRS. Positions are short-term and likely to change intraday.