How To Play The Relief Rally

Includes: SPY
by: Phillip L. Clark

Since August, stocks have remained in constant flux, with some trading sessions giving way to extreme volatility. Mid-month, September is looking more benign than history would suggest, and the last four days seem to support the beginning of a bullish trend. After all, stocks are trading at 15% to 20% discounts compared to their highs earlier this year. Maybe stocks have reached that “extremely cheap” status, and investors are ready to jump in and take advantage of the storewide sale. Or perhaps this is a simple case of an emotion-based relief rally. If that is the case, look out below!

The Commerce Department has lowered its GDP growth estimates for 2Q11 to 1.0% from 1.3%. This early sign of continued slow down has taken hold and the economy appears to be in a Japan-style long-term slowdown. Since 2007, real GDP has decreased at an average annual rate of 0.3%; but we have seen worse. During Q4 2008, we contracted a staggering 8.9%. During the first half of this year, personal consumption turned negative and imports rose in spite of the weak dollar. With consumer spending accounting for nearly 70% of the country’s wealth, confidence and jobs remain the catalyst to revive our fragile economy. GDP forecasts below 2%, however, almost guarantee companies will refrain from hiring.

Unemployment claims are trending higher, with the latest number at 428,000 or 11,000 above expectations. The economy produced zero jobs for the month of August (the worst performance since September 2010) and the unemployment rate remained at 9.1% for the second straight month; jobless claims have stayed above 375,000 since February. Businesses, like consumers, have lost confidence in the recovery and remain opposed to additional hiring. At least the untoward jobs report wasn’t due to layoffs.

Now President Obama has a plan to stimulate the economy with a $447 billion relief package, but it will do little more than grow our debt and potentially cause another circus act around raising the debt ceiling. This kind of political rambling could prove detrimental to an already contracting economy. US Treasury Secretary Tim Geithner travels to Poland Friday to meet eurozone finance ministers in an attempt to voice Obama’s disappointment with their leadership. Perhaps Geithner’s time would be better spent making the same argument to domestic leaders.

Our continuing weak dollar, courtesy of pathetic policymakers, should make U.S. goods more attractive for global markets. This is good news for the U.S., as we have become a nation of exports and perhaps nothing more. The CRB Raw Industrials and Metals Spot indices have been trending higher since early 2011. This might be a good sign that emerging economies, despite their recent higher interest rates to control inflation, are ready for a comeback. Notwithstanding the weak dollar, imports are advancing; this is offsetting export growth and further decreasing GDP.

To this point, I have said nothing that suggests we should be in a rally. Rather, with growth continuing to slow and profit margins being challenged, most would agree that stocks should be in free-fall. Our credit has been downgraded and Washington wants to print more stimulus, which pushes us ever closer to the brink of collapse. Real estate is showing no signs of recovery and foreclosures ticked higher in August. At best, we don’t see much growth in housing (1% to 2% through 2012).

So is this a relief rally? Before we decide, I should mention a few positives signals that could provide enough momentum in the economy to avoid another recession, at least for the next few quarters. Those are: an accommodative Federal Reserve, industrial prices are rising, and commercial credit expanding. But don’t get too optimistic. Confidence has been sapped from consumers and businesses, and must be restored before growth rates -- and consequently, the stock market -- return to normal.

Now Americans have shifted their focus from domestic issues to Europe’s debt crisis, and markets responded in the affirmative. Volatility is likely a result of contagion from Greece to Italy, and the problem is far from being settled. Turning to a technical perspective, the latest initiatives out of Europe have lifted the S&P 500 toward the 1,200 level, which came on September 14. However, I don’t see this as a reason to throw in the bearish towel and start buying; the 1,200 level has maintained a firm overhead resistance since early August. After reaching its annual low of 1,122 on August 22, the index managed to reach 1,204 on August 15. Within days, the index took a precipitous fall to 1,123. The market peaked at 1,219 on September 1 but quickly retreated to 1,154. If the S&P 500 is to stay above 1,200, Merkel and Sarkozy will need to deliver a tangible plan and stop kicking the can down the road. At least then, bulls can refocus on domestic issues and decide if stocks are ready to make a move to the upside.

I would be very cautious before launching into a full equity portfolio. Indeed, markets have rallied for several days, but nothing (fundamentally) has changed. Domestic issues abound, and Europe is making slapdash efforts at fixing their debt crisis, which remains quite serious. The possibility of a default in Europe is very real and should not be underestimated. At home, consumers are growing more pessimistic about the recovery and economic policy. The nation’s GDP is shrinking and jobs are coming at a much slower than needed pace. To reduce the 9.1% unemployment rate at all, jobless claims should be below 375,000 (weekly), and that hasn’t happened since February 2011.

Until confidence is restored, consumer spending will not be strong enough to encourage rapid job growth, which in turn slows long-term expectations. I don’t see a lot of upside in the current environment, and downside risks are substantial. Cash should be viewed as a position, and relief rallies are the perfect time to re-position in order to take advantage of lower prices ahead. If you must stay fully invested, value stocks with rising dividends get my vote.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: This information does not constitute a recommendation of any kind. All information contained herein is for informational purposes only, and does not constitute a solicitation or offer to sell securities or investment advisory services.