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Sep 30 2009
A Rally, Now What?
Nathan White
This is the most common question asked and debated in the investment world right now. Recoveries from bear markets and recessions often come in stages. While there is no way to know when one stage ends and another begins until after the fact, there are signs that help indicate what stage the market is in at a particular time.

The market has risen off the March 9th lows, and the first stage of recovery with easy gains has already passed. This stage is often marked by widespread skepticism as many investors are paralyzed by the bear market and therefore believe the rally will not last. This view is confirmed by conditions on “Main Street” where the recession is felt first hand.

The market propels upward when there is an absence of selling. This is followed by the cessation of bad news, which continues the rally as people realize the world is not going to end after all. Then, the realization hits that the worst of the recession is over, and things are bottoming out with some sort of daylight or recovery on the horizon. Skepticism abounds along the way. In no time, the market has recovered much of what was lost in the panic, leaving many investors behind.

At the beginning of October, the S&P 500 had risen about 58% from its low. This rally has been led by the severely beaten down financial sector along with material, consumer discretionary, industrial, emerging markets, and technology. These are areas we have emphasized to overweight for some time.

CONDITIONS TO EXPECT AFTER A MONSTER RALLY

We expect the uptrend to be more gradual than we have experienced over the last seven months. This “second” stage of recovery is characterized by the markets continuing to trend higher, but at a choppier pace without the velocity of the first stage. Our trading strategy is still bullish. However, for the first time in months, we are now more likely to sell some positions on rallies with the intent to replace them when the market sells off. Currently, our models still tell us to be fully invested.

The market advance has started to slow somewhat over the last month with the appearance of more a churning type of action. This is normal after a strong advance as the market tries to take a break and digest the gains. It is also due to the negative seasonal effects that tend to appear in September and October. This could be all the pause we get before another significant advance that propels the S&P over 1100.

There are many investors who are waiting for a good correction in order to get back in the market. They may not get their chance before the year ends, and many managers are feeling the pressure to get on board. With the consensus forecast for 2010 S&P earnings to come in at $75/shr the market could easily push into the 1100-1200 range applying a P/E of 15, which is by no means is overvalued on historical terms. There is also still a tremendous amount of cash on the sidelines with the potential to come into the market as confidence in the recovery grows. Growth could easily surprise people to the upside in the near to intermediate-term, solidifying the uptrend.

If corporate earnings come in above analyst estimates in October, this could move the market higher. Analyst estimates on the whole are too low, and it will not be hard for companies to beat expectations. As analysts play catch-up with their estimates in order to price in growth, it will provide more wind at the market’s back. The negative seasonality effects fade away as October progresses and often gives way to a positive seasonality effect for the last part of the year. These “year-end” rallies can take place anywhere from late October through to the end of the year.

MARKET OBSTACLES

Now, if you think I am an overly confident bull that is looking at the market through rose-colored glasses, let me talk about potential bumps in the road or factors that could signal an end to the market advance. Lately, most of the positive earning surprises have come from the cost-cutting efforts that occur as companies tighten their belts when going through an economic downturn. This is normal and healthy because it causes companies to shed inefficiencies and focus on performing better and smarter. The cost cutting efforts have helped corporate earnings to recover and stabilize. However, in order to justify growth and valuations, there must also be a recovery in sales. Sales typically lag earnings at this point in the economic cycle and often do not bottom out until about 9 months after the end of a recession. This recovery in sales is the crucial next step for earnings sustainability, and is something we are watching. Without it, the economic recovery could be in suspect.

Our sentiment indicator is also nearing the caution zone. Sentiment is significant when it reaches extremes in bullishness or bearishness. It signals that most market participants embrace the same point of view, they are either too optimistic or too pessimistic. When this occurs, we usually take the opposite or contrary point of view. Right now sentiment has entered the optimistic zone, but is not yet overly optimistic. If it does move into the overly optimistic zone, then we would probably sell positions and move to a more defensive posture.

We are also monitoring market internals such as new highs vs. new lows, percentage of stocks above their moving averages, advancing vs. declining volume in order to gauge the continued strength of the market advance. Other concerns such as the continued debt problems, negative effects of increased regulation, higher taxes and inflation are significant but are longer down the road and require too much guess work as to the manner and timing to which they will unfold. We prefer to work with what the market is doing presently. For now our models tell us there is more risk being out of the market than in.