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Expect a Rally as Waders Dive In

Expect a Rally as Waders Dive In
By VITO J. RACANELLI  MONDAY, JULY 20, 2009

Wary investors may be goaded into taking the plunge.

HARKEN BACK TO YOUR CHILDHOOD WHEN ON A sweltering summer day you stood at the edge of a pool, hesitating, thinking about jumping in. You were a little scared. The water would be a cold shock to your skin. But it was something you had to do to get to the fun. Some kids jumped in head first. Others waded in slowly, getting acclimated to the water temperature.

In the stock market, the waders might soon be getting in, setting up a new -- if only temporary -- leg up for stock prices. The jumpers got in first, during the spring, when the water was the coldest and the doom greatest. So far, they've been having fun as the waders watched.

Even as the market has rallied 41% from March lows, mainly fueled by macroeconomic news getting less bad, skepticism and bearishness remain the order of the day among many professional investors. Those would be the waders.

In recent client visits, for example, John Roque, a managing director and chief technical guru at WJB Capital Group, says customers "are pretty bearish and skeptical of the rally." They point to the still-poor economic fundamentals, like unemployment levels, and increased taxes and regulations, among other worries, that led to the March low.

Anecdotally, our chats with money managers also reveal skepticism is common. But that's the basis for another leg up and the rally continuing, at least for a short while.

"Deeply oversold, worsening sentiment and positive internal divergences almost always provide the foundation to stock-market recovery," notes Douglas Kass, a general partner of Seabreeze Partners, an oft-noted bear. Kass, who correctly called the bottom in March and even the June-July pullback, expects some sideways summer action before a liftoff in the early fall -- as the waders finally get in -- with the Standard & Poor's 500 index rising to 1025-1050, a double-digit jump.

Among the divergences he cites: From October 2008 to March 2009, the volume traded on the New York Stock Exchange was gradually drying up, and fewer and fewer stocks made new lows. This improvement was happening even as stock indexes fell to new lows.

It's bullish when bearish sentiment meets with improving market internal indicators, Roque adds. In this most recent mini-pullback since June 11, indicators such as the 10-day moving average of NYSE new highs and the percentage of NYSE stocks above their 200-day moving averages "broke out" to new highs, even as the S&P 500 failed to surpass the June 11 high. Additionally, the NYSE cumulative breadth made a new 2009 high.

The 950 level on the S&P 500 appears to be where many investors are prepared to short the market, and this suggests the S&P will probably go through the 950 level, perhaps sharply higher, if huge short covering eventually is triggered, Roque asserts.

The move up, if it comes, could be swift, as waders give in after watching jumpers splash around. "If the momentum moves to the upside, then it ends up that guys jump in even if they don't want to," quips Quincy Krosby, the market strategist at Prudential Financial, and, we must admit, the originator of the pool analogy.

Skeptics point to the VIX index, which gauges market volatility, and note it is down to low levels, suggesting investors are too complacent. That spells a set-up for a leg down, they argue. Yet the last time the VIX was at current levels, about 24-25, it was pre-Lehman bankruptcy and the S&P 500 was 1250, a third higher than current levels. Investors are only more complacent than they were a few months ago, when the market hit 12-year lows and the end seemed nigh.

In coming months, Kass says the fear of being out will overcome fear of being in. Kass believes the March low of 666 on the S&P 500 might mark a generational low, but please don't mistake Kass -- or us -- for bulls. Huge bull rallies inside bear markets are hardly unusual. The long-term market headwinds haven't gone away, he notes. In addition to the macro concerns Roque cited, Kass lists an elevated savings rate, which lowers consumption; spreading wage deflation; the devastation of the construction and real-estate industries, once big job creators; and a reduced securitization market, a former growth engine, as factors that will weigh on stocks for years. "These issues raise the specter of a fragile recovery and a double-dip both in the economy and stock market next year," he says. Kass sees a "lumpy and inconsistent" market for the next few years, with substandard to negative returns.

Investors have yet to reckon with a future with much less leverage, where normal corporate profit growth -- after cost cuts are exhausted -- is lackluster compared to the boom, and where typical P/Es will reflect that.