Now that we are more than 5 months into the rally, it seems like a good time to step back and see what we’ve got on our hands. I see five salient points:
- A stock market rally in the face of a contracting economy—that is, during a recession—is not unusual. Eight of the last 9 recessions have had such rallies. One might say that this is a garden-variety late-recession rally. The investors driving the rally are reacting to the anticipation of the end of the recession, not to actual current growth in the economy. There is no broad current growth in the economy—we are still in recession. The catalyst for the rally was/is the anticipation that the recession will end within a matter of months.
- That anticipation, in turn, has been upported by “green shoots”—that is, indications that the recession was ending. Green shoots do not have to indicate that the economy is expanding. Data that suggest that the economy is getting “less worse,” or declining at a slower rate, qualify. Obviously, for any economic contraction to end, it must first slow down its rate of contraction, reach a point of inflection, and then start actually expanding. So a data point that suggests the economic contraction is slowing, or is cause for optimism on some level, “counts” as good news.
- Because the rally is in anticipation of the end of economic contraction, the market is basically sentiment-driven. Good news helps the rally along, bad news slows it down or reverses it. The fact that the rally is sentiment-driven is the answer to those who have been surprised and perplexed by its sustainability. Such investors and writers have insisted that the rally is not supported fundamentally, therefore it must fail. They are correct that it has not been supported fundamentally. But they have underestimated the power of “less bad” news, or signs of a slowing contraction, to create and sustain a rally. For example, about 75% of companies beat consensus earnings estimates in the second quarter. During the reporting period just ending now, the market advanced by about 14%. Clearly, it was the beating of the estimates that the market relied on to bid up the prices of stocks during this period. The facts that those estimates had been lowered significantly to low hurdles, and that most earnings were significantly reduced year-over-year, were not driving sentiment—beating the estimates drove sentiment.
- Since the rally began on March 10, the net news flow has been, on average, pretty steady in indicating slowing contraction and a coming end to the recession. Therefore the rally has continued more or less steadily, with only an 8% pullback during June and July to interrupt its progress. The rally has expanded the value of the S&P 500 by more than 45% since it began in early March.
So what we have is a late-recession, sentiment-driven rally, where the predominant sentiment has been that the recession is ending and the economy will soon start to expand.
But we have reached a point that expectations are now built into the market of an actual end to the recession and an impending turnaround into an expanding economy. The market is not “priced for perfection.” Rather, it is priced for an end to the recession and the beginning of economic expansion. (It may or may not have gotten a little ahead of itself in anticipating an end to the recession and the beginning of economic expansion--which is to say, a correction may be in order.)
Over the next few weeks, the expectations placed on the news flow will become different: “Less bad” news will, at some point, no longer count as “good” news sufficient to support a continuation of the rally. Instead, the market will start to demand data that show:
--The Conference Board’s Index of Leading Economic Indicators continues to rise each month without interruption.
--Consumer confidence is rising.
--Consumer spending is increasing. Look to the back-to-school season as an important indicator here. At more than two-thirds of economic activity, consumer spending is a necessary factor in an economic recovery.
--Manufacturing is increasing, and manufacturing capacity is being utilized to a fuller degree. -----Inventory reductions are continuing.
--Real estate sales are picking up. Better yet would be data that housing prices have stopped falling, but just an expansion in residential sales activity would probably be good enough for awhile.
--Earnings are growing on a sequential basis, and closing the gap significantly on a year-over-year basis. Since the next reporting season is two months away, look for rising estimates, optimistic guidance, and the like. Everybody is aware that Q2’s earning’s “successes” were built upon layoffs and cost reductions, not expanding business activity. Indeed, most companies reported drops in revenue in Q2. That won’t cut it for very much longer.
--Stock valuations are not heading into the stratosphere. Note: Investors already seem to have signaled that they are willing to look past the S&P’s soaring trailing P/E ratio (the result of Q4 2008’s dismal negative earnings), and to consider projected P/Es, or P/Es calculated on operating earnings, in valuing stocks at the current time.
--Layoffs are slowing significantly, jobs are being created, and initial unemployment claims and the unemployment rate are both falling.
There are those who say that good news of this kind is impossible, because both consumers and businesses are deleveraging and will not be expanding their activities any time soon. There is certainly logic behind their point, but I believe that nobody knows the future. After all, the market has surprised many for five months now, there is certainly a possibility that it might continue to do so for another month or two. My suggestion is to listen to the news flow, keep current with what’s actually happening in the market, and protect long positions with hedges or simple sell-stops.
