Possible Scenario for a Market Rally

Includes: EUO, FXE, SH, SPY, UDN, UUP
by: Chris Ciovacco

The bearish outlook is well documented with extensive coverage of the problems in Europe and the "dawn of the next credit crisis". We understand and respect the bearish case. We also understand and respect the seriousness of the debt problems in Europe. However, since the market’s longer-term stance remains positive, it is also reasonable to assume the problems of the day may not yet derail the bull market. During corrections, it is nearly impossible to conceive stocks will ever go up again, much less have any chance of rallying to new highs. With all the bearish views, we will present a contrarian scenario that could lead to a better than expected rally in stocks:

    • The general backdrop of the markets points to a rally (oversold, high degree of pessimism, numerous people betting on declines with shorts, heavy capitulation-type selling on strong volume, positive divergences, calls for a "new bear market").
    • The market's health prior to the current correction was excellent, which says higher highs (above 1,220 on the S&P 500) have a realistic chance of occurring despite seeming almost impossible from where we sit now. Higher highs may not happen, but they cannot be ruled out based on the facts presently in hand.
    • Any positive economic news from any corner of the globe could propel markets higher. Oversold and pessimistic markets tend to react very favorably to anything that can even remotely exceed low expectations.
    • Gains tend to feed off themselves; if the S&P 500 can make a few intermediate higher highs in the next few weeks, momentum could surface rapidly since most of the sellers sold out in recent weeks. With greatly diminished selling pressure in the short-run, even a relatively small group of buyers can take control of prices and drive them higher.
    • The Euro is significantly oversold and has significant positive divergences that point to a possible rally. The news stories in the coming days and weeks may read something like this: The problems in Europe are serious, but the selling has been overdone. Budgetary problems have been pushed out into the future giving countries some breathing room in the short-term. The Euro may be in trouble in the longer-term, but it is not going anywhere in the short-to-intermediate term.
    • The U.S. Dollar is overbought and has some negative divergences on its chart; although they are not as pronounced as the divergences on the chart of the Euro.
    • If the Euro rallies and the Dollar at least stops rising like a rocket (or declines for a time), risk assets in general could benefit (stocks, commodities, and commodity-dependent currencies).
    • Finally, the Fed could say the economy is doing a little better, but conditions still warrant interest rates remaining low for “an extended period”. That statement alone could give commodities and emerging market stocks a much needed boost. The Fed is smart enough to know the financial markets cannot withstand any comments related to raising rates. Our bet is the Fed is on hold at least until 2011.

Bullish Outcomes Probable - Bearish Outcomes Possible:

Is it possible that none of the above occur in the coming weeks and months? ANSWER: Absolutely, positively yes – none of it may happen. Stocks could make lower lows and a correction could go on for a few months. Worse yet, stocks could shift into a full blown bear market in the coming weeks and months. This exercise is meant to counterbalance all the negativity that has ruled the mind of the market in recent weeks. Just when we think nothing good can happen and stocks go nowhere but down, they often surprise on the upside. The best thing we can do is to continue to pay attention with an open mind about bullish and bearish outcomes. The evidence, while significantly weakened in recent weeks, continues to support the bulls for the time being. Until that condition changes, we will continue to give the bull market the benefit of the doubt. Having the S&P 500 trade over 1,220 seems nearly impossible right now, which makes it more probable than we think.

Disclosure: The author and CCM clients have numerous positions in the stock, commodity, and currency markets. Long UDN.