Does stock market rally have legs?

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Global stock markets rallied for a second consecutive day after the US government agreed to rescue the beleaguered Citigroup (C) and as President-elect Obama introduced his administration’s new economic team, emphasizing the need for quick action to hasten an economic recovery and signaling that he may be willing to keep at bay higher taxes for the wealthy.

The MSCI Word Index has improved by 10.1% since the start of trading last Friday, whereas the MSCI Emerging Markets Index lagged somewhat and registered a more modest gain of 4.6%.

The table below shows the performances of various global stock markets over the past two trading days, as well as figures since the respective markets’ highs and for the year to date (all in local currency terms).

Click on the table for a larger image.

gs-24-nov.jpg

The Dow Jones Industrial Index rose by 11.8% on Friday and Monday – only the 13th time since 1896 that the Index has had a two-day winning streak with a gain of more than 10%, according to Bespoke. “In prior occurrences when the Dow had one of these rallies following long periods of declines (-30% over 200 trading days), the average returns were notably more positive. While the next day had typically been negative, over the next week and month the average returns improved significantly.”

One must be careful not to attach too much value to one- or two-day movements, but should also be cognizant of the fact that stock markets bounced off multi-year chart support levels near the 2002 lows.

I said the following in my “Words from the Wise” review on Sunday: “Oversold conditions are bound to result in rallies from time to time (and possibly around Thanksgiving), but these should not be trusted at face value. For a more lasting market turnaround to happen, I would like to see evidence of base formations on the charts, a 90% up-day, and relative outperformance by the financial sector.”

At the time of writing, no confirmation had been received on whether yesterday was a 90% up-day, but the market’s volume and breadth indicators were certainly was not too shabby. Although the past two days’ outperformance of financials (Financial SPDR +18.7%) and banks (Philadelphia Bank Index +18.3%) is encouraging, it is too early to mark a new trend as far as relative performance is concerned.

I also alerted readers on Sunday that I was “closely monitoring the surges in the US dollar and Japanese yen – low-yielding currencies previously used for funding risky investments – as a break of the uptrends in these two currencies will be a good indicator of the forced deleveraging selling starting to subside. Once this situation has played itself out, we should see a return to lower volatility levels and a return of confidence.”

It is on this front that yesterday’s news was quite encouraging. Both the US dollar and the Japanese yen lost grounds. As a matter of fact, the trade-weighted US Dollar Index (-2.2%) experienced its worst day since 1985, and its 5th worst day since 1970.

25-nov-1.jpg

Adding more credence to the bounce in stock markets is the fact that consistency occurred across asset classes as oversold commodities rallied (Reuters/Jeffries CRB Index +5.4%, West Texas Intermediate crude +9.2%, and gold bullion +3.6%) and overbought bonds corrected (+17 basis points in the case of the ten-year US Treasury Note yield).

Also consistent with the fact that investors have gained somewhat more confidence in risky assets, is the 20% decline in the CBOE Volatility Index (VIX) over the past two trading days. The VIX is strongly inversely correlated to the movements in stock markets, using the Dow Jones World Index as an example in the graph below.

25-nov-2.jpg

A final positive for the bulls is that the period post Thanksgiving through the end of the year has usually been a strong time for stocks. Also, according to Jeffrey Hirsch (Stock Trader’s Almanac), “December is normally a banner month for stocks, ranking second [on the monthly calendar] for the Dow and S&P 500 and third for the Nasdaq.”

Should the bullish seasonal tendencies hold true on this occasion, the next question is what the magnitude of the potential rally might be. The table below shows the November 4 highs and 50-day moving average levels for the major US indices, together with the increases that will be required to reach these levels. Although this is guesswork, these levels could be initial rally targets.

25-nov-table-d.jpg

I remain wary of rallies as the primary trend of the market is still bearish and it may not be out of the woods yet. A reminder of the ugly economic reality can again show when poor earnings numbers are announced by the start of the next reporting season in mid-January. In the meantime, enjoy whatever further upside the rally may have in store.

 

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3 comments to Does stock market rally have legs?

  • Ian Nunn

    As a casual observation, strong moves in the market seem to correlate with strong moves in fiscal and monetary policy. Whether this is attribution bias or a causal connection or a causal connection due to attribution bias on the part of investors, I do not know.

    However, if it takes a multi-billion dollar bailout announcement or the creation of some wonderful new program for saving the finance system, to stimulate bullish behavior, what happens when we a) run out of money (of course Zimbabwe suggests the counter example that we won’t) or b) run out of innovative stimulus programs (the counter example would be in the hiring by the Fed, of the geniuses whose endless creativity gave us the incomprehensible credit instruments that caused the problem in the first place).

    Maybe this time, the economic system will make its natural and necessary correction despite every attempt by authorities to prevent it.

    Of the market, it seems to me there remain bulls to be crushed but not underlying fundamentals to support a new bull market yet.

  • Frank Wordick

    1) A long-standing rule in the stock market game is that those stocks that fall the least in a downturn post the strongest advances in the following upturn. The financials have had the crap kicked out of them and continue to suffer badly. Consider the recent fate of Citicorpse! Therefore, waiting for the financial sector to come roaring out of the box may be like “Waiting for Godot” to arrive. Incidently, the grade assigned by the stock exchange to Citigroup, namely “C”, would in my opinion be better changed to “F”.
    2) Some asset managers are anticipating a week of thin trading. This means that whatever happens should not be taken too seriously.
    3) I’m not sure what the market bounced off of during the recent low. The 2002 low was around 7200, I believe. Was the market bouncing off of that or 7000 or something else? 7500 doesn’t seem to mean anything in particular, a message that I find somewhat ominous.
    4) So far we have had a 10%+ rally. This is not exactly spectacular, particularly considering that it is coming off a big dip. What next?
    5) Some currency analysts think the dollar will be strong for a fair while — probably well into next year.
    6) These big year end rallies that typically extend into January of the following year occur during good times, when white collar workers receive big year-end bonuses. Think anyone except board members and senior executives will be slopping at the trough this year?

  • [...] posed the following question a few days ago: “Does the stock market rally have legs?” We have now had four days in a row of a higher market, something we have not seen since June [...]

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