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.

Timing Outlook Stays Positive

1. Summary

Today's Timing Outlook reading is 9.0, or “positive,” down from 9.5 last time. That makes 9 of the last 10 readings positive, with just one “neutral” interruption a few weeks ago. The only significant change from last time is that the P/E valuation of the S&P 500 has climbed into neutral territory from positive. That is a natural outcome of the stock market's rally. The other valuation indicator that I use--Morningstar's Market Valuation Graph--did the same thing a few weeks ago.

The S&P 500 index has now stayed above its March 9 close for 24 consecutive weeks--not only stayed above it, but climbed 52% above it. As mentioned last time, it is pretty safe to say that March 9 marked the end of the 16-month bear market phase that began in October, 2007.

That said, this could still be a “bear market rally,” meaning a bull market phase embedded within a much longer bear market. But at a duration of five+ months and a magnitude of 52% gain without a significant retreat (the biggest fallback was about 8% in June-July), this rally has proved itself to be sustained and investable.

As I have said repeatedly, I have been buying into this rally since April 2, making purchases with 5% chunks of my “stock money.” After multiple purchases, my Capital Gains Portfolio is essentially fully invested. It had been 100% in cash for many months prior to April 2. I am protecting my profits with 8% trailing sell-stops. Most of the purchases have been of SPY (the ETF that tracks the S&P 500 index), with a few purchases of QQQQ (the ETF that tracks the Nasdaq 100) and IBM.

2. Market Performance Since Last Outlook

New Outlook (8/27/09): 9.0 (POSITIVE)

Last Outlook (8/12/09): 9.5 (POSITIVE)
S&P 500 last time (8/12/09): 1006
S&P 500 now: 1031 Change: +2%

S&P 500 at beginning of 2009: 903
S&P 500 now: 1031 Change YTD: +14%

S&P 500 at close 3/9/09: 677
S&P 500 now: 1031 Change since 3/9/09: +52%

3. Indicators in Detail

--Conference Board Index of Leading Economic Indicators: New report issued August 20 increased for the fourth straight month. Positive. +10

--Fed Funds Rate: No change since last time. The Fed Funds rate remains < 0.5%. Ten cuts (with no increases) since 8/07 brought the rate to near zero, plus many Federal programs continue to inject money into the economy. +10

--S&P 500 Market Valuation: According to Morningstar, the S&P 500’s P/E rose from 17.0 to 18.1. At a value above 17.4 but below 19.3, this indicator weakens from positive to neutral. +5

--Morningstar’s Market Valuation Graph is 1.00 for the third time in a row. This means that Morningstar feels that the ~2000 stocks they cover, taken as a whole, are fairly valued. That makes this indicator neutral. (Historical data: All-time low = 0.55 on 11/20/08. Value at end of dot-com bear market = 0.78 in 10/02, which kicked off a 5-year bull market. Most recent low of 0.62 coincides with market’s March 9 low.) +5

--S&P 500 Short Term Technical Trend: The S&P 500’s chart remains positive. The index and its three key simple moving averages (SMA) line up in the most positive way. For this indicator, we look at the two shorter SMAs: index > 20-day SMA > 50-day SMA. That’s the most bullish arrangement you can have. +10

--S&P 500 Medium Term Technical Trend: Same story. This indicator considers the index and the two longer SMAs. We have index > 50-day SMA > 200-day SMA. Also, as noted last time, the 200-day SMA has bottomed out and is now itself in an upward trend. +10

--DJIA Short Term Technical Trend: Same story as with the S&P 500 chart. Positive. +10

--DJIA Medium Term Technical Trend: Same story. +10

--NASDAQ Short Term Technical Trend: Same as S&P 500 and DJIA. Positive. +10

--NASDAQ Medium Term Technical Trend: Same story. Positive. +10

TOTAL POINTS: 90 NEW READING: 90 / 10 = 9.0 = POSITIVE


-->The SensibleStocks.com Timing Outlook is a tool to help you make better buy, hold, and sell decisions. Its mission and design is to suggest the likely direction of the market over short time periods (2-4 weeks). Find out more about how it works by clicking here. Track my Capital Appreciation Portfolio by clicking here.

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What Kind of a Rally Is This?

Since shortly after the current rally began on March 10, I have taken the position that the stock market rally made sense and could well continue.

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.

Timing Outlook Remains Strongly Positive

1. Summary

This Timing Outlook reading is 9.5, or “positive,” up from 9.0 last time. That makes 8 of the last 9 readings positive, with just one “neutral” interruption a few weeks ago.

The S&P 500 index has stayed above its March 9 close for 22 consecutive weeks. It is pretty clear now that March 9 marked the end of the bear market that began in late 2007. That is not to say that this may not be a “bear market rally,” that is, a short-term bull market contained within a much longer bear market. But at five months duration and a 49% gain without significant retreat (the biggest drawdown was about 8% in June-July), this rally has proved itself to be sustained and investable.

I have been buying into it in 5% chunks of my “stock money.” My first purchase was on April 2, and after multiple purchases, my Capital Gains Portfolio is now >90% invested, after having been 100% cash for many months during the bear market. If the market keeps going up, I will make one or two more purchases, exhaust available cash, and be 100% invested soon. I am protecting profits with 8% trailing sell-stops.

2. Market Performance Since Last Outlook

New Outlook (8/12/09): 9.5 (POSITIVE)

Last Outlook (7/25/09): 9.0 (POSITIVE)

S&P 500 last time (7/25/09): 979
S&P 500 now: 1006 Change: +3%

S&P 500 at beginning of 2009: 903
S&P 500 now: 1006 Change YTD: +11%

S&P 500 at close 3/9/09: 677
S&P 500 now: 1006 Change since 3/9/09: +49%

3. Indicators in Detail

· Conference Board Index of Leading Economic Indicators: No new report since last time. This indicator has risen for three straight months, making it positive. +10

· Fed Funds Rate: The Fed Open Market Committee met today, and in its report, it did not raise rates, and it indicated no intent to do so for awhile. The Fed Funds rate remains < 0.5%. Ten cuts (with no increases) since 8/07 brought the rate to near zero, plus many Federal programs continue to inject money into the economy. +10

· S&P 500 Market Valuation: According to Morningstar, the S&P 500’s P/E rose from 15.8 to 17.0. Still below 17.4, so this indicator remains positive. +10

· Morningstar’s Market Valuation Graph is 1.00, same as last time. This means that Morningstar feels that the 2000-or-so stocks they cover, taken as a whole, are fully valued. That makes this indicator neutral. (Historical data: All-time low = 0.55 on 11/20/08. Value at end of dot-com bear market = 0.78 in 10/02, which kicked off a 5-year bull market. Most recent low of 0.62 coincides with market’s March 9 low.) +5

· S&P 500 Short Term Technical Trend: The S&P 500’s chart remains positive. The index and its three key simple moving averages (SMA) line up in the most positive way. For this indicator, we look at the two shorter SMAs: index > 20-day SMA > 50-day SMA. That’s the most bullish arrangement you can have. +10

· S&P 500 Medium Term Technical Trend: Same story. This indicator considers the index plus the two longer SMAs. We have index > 50-day SMA > 200-day SMA. Not only that, the 200-day SMA has bottomed out and is just beginning to go up, also a bullish sign. +10

· DJIA Short Term Technical Trend: Same story as with the S&P 500 chart. Positive. +10

· DJIA Medium Term Technical Trend: Same story. +10

· NASDAQ Short Term Technical Trend: Same as S&P 500 and DJIA. Positive. +10

· NASDAQ Medium Term Technical Trend: Same story. Positive. +10

TOTAL POINTS: 95 NEW READING: 95 / 10 = 9.5 = POSITIVE

• The SensibleStocks.com Timing Outlook is a tool to help you make better buy, hold, and sell decisions. Its mission and design is to suggest the likely direction of the market over short time periods (2-4 weeks). Find out more about how it works by clicking here. Track my Capital Appreciation Portfolio by clicking here.
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