Is The Stock Rally Over?

by: Eric Parnell, CFA

"It ain't over till it's over"

-Yogi Berra

The stock rally that began late last year is not over. But its time may soon be running out.

Stocks have endured a bumpy last few weeks. After peaking intraday at 1422 on the S&P 500 on April 2, which was the first trading day of the second quarter, stocks (NYSEARCA:SPY) have been on the fade. Overall, stocks have declined by as much as -4.6% in the days since its recent peak and is still down -3.1% through Friday's close. But this decline is modest when considered in context of the swift rally that preceded it over the last several months and was long overdue from a technical perspective. And despite the recent pullback, the price uptrend for the broader market remains firmly intact. Specifically, the S&P 500, which represents the U.S. Large Cap segment of the equity market, continues to hold support at its 50-day moving average. Impressive resilience to say the least.

Pressure is mounting on the S&P 500 to keep its current uptrend intact. Technical factors are showing signs of meaningful weakness including an RSI that has been locked below 50 since early April and momentum readings that are definitively in decline. Also, many other major stock market indices have already made an initial break to the downside. These include U.S. Mid-Cap (NYSEARCA:MDY) and U.S. Small Cap (NYSEARCA:IWM) stocks, both of which already sliced through support at their respective 50-day moving averages at the beginning of April.

The view appears even worse when looking outside of the U.S., as both Developed International Stocks (NYSEARCA:EFA) and Emerging Market Stocks (NYSEARCA:EEM) have been fading for more than a month now with 200-day moving average lines that remain in a steadily downward sloping trend.

This backdrop for the S&P 500 raises an important question. Does it have the power to continue to rise, or is it likely to succumb in the coming months?

Challenges are certainly building for the stock market in this regard. First, it appears that hopes about a sustained economic recovery in the U.S. are once again on the fade, as recent data over the last few months have been riddled with signs of weakness. More worrisome is the situation in Europe, as the threat of crisis that once centered on smaller periphery nations such as Greece is now increasingly focused on much larger core countries like Spain and Italy, both of which are among the top 12 economies in the world including Italy whose debt market is the third largest. This along with the fact that growth in Asia is also slowing suggest that the economic fuel to drive continued stock market gains may be difficult to come by as we progress from here.

But recent history has taught us about one important caveat to any stock market outlook. This, of course, is Fed policy. For as long as the Fed has been actively engaged in stimulus, the stock market has shown the ability to shrug off the most disconcerting news to not only hold its ground but advance to new heights. Conversely, history has also shown us that once Fed stimulus goes away, the stock mood can quickly turn dark.

So with this important caveat in mind, where exactly do we stand with Operation Twist, which is the Fed's latest stimulus program whose launch last October coincided to the day with the beginning of the current stock market rally. Operation Twist is scheduled to conclude at the end of June. Thus, investors have slightly more than two months to enjoy Fed support before the market is once again left to go it alone.

With this fact in mind, what might we expect from the stock market during this intermediate phase between now and the end of Operation Twist? History provides a good starting point in evaluating the market's prospects.

The stock market performed quite well during the final two months before the end of QE1 on March 31, 2010. Overall, stocks gained a healthy 9% during this stretch. Thus, the potential for further gains certainly exist over the next two months under this premise. A retest of the recent 1422 peak on the S&P 500 or another leg higher on the index would not be ruled out based on this framework.

Of course, the same cannot be said in the final two months leading up to the end of QE2, as stocks declined by as much as -7% over this time period. This reaction was notable given that it was the second time around for the market experiencing stimulus withdrawal. While it could be argued that other factors were at work at the time, it may have also been driven by the fact that the market was anticipating what eventually struck in July and August once Fed stimulus was withdrawn.

Bottom Line

The current stock market rally is not yet over. And the potential exists for the stock market to advance higher in the coming months. But gains are likely to be harder to come by at this juncture, particularly with the end of the latest Fed stimulus program in Operation Twist looming around the corner in June. In recent years, the market has reacted violently once Fed stimulus is removed, and this is a fact that is no longer lost on investors this third time around. As a result, pressure to the downside for stocks may increasingly build as we move toward the summer.

Of course, two particular outcomes could dramatically impact this stock market view.

On the upside, if the Fed were to announce another major stimulus program to begin not long after the end of Operation Twist, stocks would likely receive a boost that could be sustainable through much of the rest of the year (as a reader on one of my recent articles astutely pointed out in a comment, watch for the Fed talking about "Sterilization" in the coming months. This of course is another way of saying Operation Twist, but the Fed has benefited this last time around from the cover provided by the name change on its latest stimulus program).

On the downside, the list remains long. This includes the outbreak of crisis in Spain and/or Italy. Or how the Presidential election turns out in France. Or the threat of an incident at the upcoming Summer Olympic Games in London (another great point from a reader on a recent article). Or the outbreak of conflict between Iran and Israel in the Middle East. Or some other geopolitical event that is currently unanticipated. Any of these forces have the potential to overwhelm any remaining upside forces resulting from the final months of the Fed's current stimulus program.

These counterbalancing forces highlight the importance of staying hedged in investment portfolios. This includes keeping stock allocations proportional to other asset classes. Emphasizing the more defensive areas of the market that performed best leading up to the end of QE2 and have underperformed during much of Operation Twist also has merit within stock allocations. This includes holdings in names like McDonald's (NYSE:MCD), HJ Heinz (HNZ) and Tootsie Roll (NYSE:TR).

But the better opportunities at this juncture continue to reside outside of the stock market. This includes an allocation to Gold (NYSEARCA:GLD), which has trailed since before to the launch of Operation Twist late last year and is overdue to begin catching up given that the threat of crisis and propensity toward competitive currency devaluation remains elevated. Positioning in Municipal Bonds (NYSEARCA:MUB) and Agency MBS (NYSEARCA:MBB) may also be worthwhile. Municipal Bonds remain attractive following a recent pullback and Agency MBS would likely be the focus of the next Fed program if they indeed opt to move ahead with another round of stimulus at some point in the future. And Long-Term Treasuries (NYSEARCA:TLT) remain an ideal option to hedge against the stock market.

The next few months promise to be most interesting for investment markets. Stay closely tuned.

Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

Disclosure: I am long GLD, TLT, MCD, HNZ, TR, MUB, MBB.