Why This Rally Has Been Sustained

This is the fourth in a series of articles that have explored the nature of the current bull market rally. The previous articles were:
-- "What Kind of a Rally Is This?" (August 17)
-- "Is This Rally Sustainable?" (June 3)
-- "Are We There Yet?" (April 20)

The rally--many would flat-out call it a bull market, including me--has now reached almost six months in length. After a rocket start, the rate of ascent has slowed, but overall the rally has been remarkably consistent: +9% in March, +9% in April, +5% in May, flat in June, +8% in July, and +3% in August. The overall gain has been 51% since the S&P 500's close at 677 on March 9. If you define “correction” as a 10% pullback, there has been no correction along the way.

There are those who contend that the rally is somehow invalid, or contrived, because the rally is unsupported by fundamentals. In contrast, I believe that this rally has been fully supported by fundamentals, although I suspect many will disagree with how I define “fundamentals.” Here is my reasoning in three easy steps:

First, too many investors, while recognizing that both the stock market and the economy run in cycles, believe that the cycles must be concurrent. That is, they think that the stock market’s value and economic fundamental values must always be directly proportionate, that they go up and down together. But that is not reality. There are often significantly long stretches when the market’s cycle and the economic cycle are out of phase. That has been consistently true in recessions. In eight of the last nine recessions, the stock market has anticipated the end of the recession by an average of about six months. The market displays its anticipation by going up while the economy is still going down. In April, after watching the market go up for more than three weeks, I postulated that would happen again. It has, making it now nine out of the last ten recessions that the market has made a significant increase during the recession.

Second, it follows that it is reasonable to define fundamental economic metrics as “improving” if they are getting worse at a slowing rate. Such fundamental economic measures as the GDP, employment rate, consumer confidence, the Conference Board’s LEI (Index of Leading Economic Indicators), reports from ISM (Institute for Supply Management), housing prices, credit availability, and the like, do not have to be actually going up to be “improving.” They may still be dropping toward their eventual trough—the economy may still be contracting—but the important observation is that the rate of contraction is slowing. If that is happening, then you can reasonably infer that the recession is in fact reaching its late stages. By definition from the National Bureau of Economic Research (NBER), which has quasi-official status in such matters, a recession ends when the economy stops contracting.

Third, what I call the “net news flow” has been kicking out many data points for months now that economic fundamentals were in fact getting worse at a slowing rate. In the past couple of months, a few of the fundamental economic measures have reached individual inflection points and actually started to rise. For example, the LEI have been going up for four months. More recently, housing prices (as measured by the Case-Shiller Index) have stopped falling and have risen in some metropolitan areas. Of course, the news is often lumpy and seemingly contradictory. That’s life and is why I call it “net news flow.” The point is that the “average” of all the economic news, taken as a whole, has been going in the right direction since this rally started.

That is why I believe that this rally has been fully supported by economic fundamentals. As you can guess, I disagree with the critics of “green shoots.” The market runs on investor sentiment. It is the green shoots that have fueled this rally, giving hope to investors who have bid up stock prices in the belief that the economy first pulled back from the abyss and will begin growing soon.

I invested based on this reasoning. I maintain a publicly published Capital Gains Portfolio, a demonstration portfolio for purchasers of my book, Sensible Stock Investing, that is also available for free viewing by the curious. The portfolio was entirely in cash for many months before this rally began. But in April, I began cautiously buying into the rally, mostly through a series of purchases of SPY (SPDRS, an ETF that tracks the S&P 500). Last week, I made my final purchase. The portfolio is now 100% invested.

In addition to the cautious, gradual re-entry into the market, I’ve helped manage risk by using tight 8% trailing sell-stops. None of the stops has been hit. All positions are in positive territory. Because of the gradual investments, the portfolio’s performance this year is a bit behind the S&P 500’s. That’s OK. Because the portfolio was in cash for so long, it did not suffer as much from the crash that preceded the rally, so overall the portfolio is way ahead of the S&P 500 benchmark index since its inception. Risk management is very important; it helps you avoid severe consequences of being wrong.

Where is the market going from here? I haven’t given that much thought, to be honest. Now that I am fully invested (no new money goes into the portfolio other than dividends it generates), I have no more decisions to make for a while. My exit strategy is already in place via the sell-stops. From time to time, I may play with the stops (tighten them, loosen them, or use a moving average rather than a flat percentage to set them), but I do not need to anticipate the market’s next major move. Past readers of my articles may recall that I believe in “waiting for the turn” anyway. When the market does turn down, my sell-stops will get me out of there.

That said, I think that strong arguments can be made for at least three scenarios:
--The market will make a correction (that is, contract by more than 10%), then resume its expansion if the news warrants it;
--The rally will continue for some more time, without a correction, anywhere from a few weeks to many months, depending on the news flow; and
--The rally will end and the market will reverse and begin to contract. This is what I think will happen if the net news flow turns clearly negative. So if, as many believe, we are in for a double-dip recession, signs of that will show up in the news flow, and the market (again leading the economy) will anticipate that and go backwards.