When will the rally end?

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I published a post a few days ago on the issue of whether stock markets were in a secondary (i.e. cyclical bull) or primary bull market.

I quoted a research project by Ned Davis (Ned Davis Research) in which he identified seven dimensions one could use to compare the March 9 low with secular lows of the past. The research showed that only one of the seven criteria indicated a secular bull was in place, whereas three were neutral and three were bearish. Although Davis believed the nascent rally had more upside potential, he concluded, like Richard Russell, that we were dealing with an extended rally (cyclical bull phase) within a secular bear market.

Davis has now turned his focus to what criteria would signal that one should exit the rally. His yardsticks were reported by Mark Hulbert on MarketWatch and are as follows:

(1) Valuation. Davis would look to exit from stocks whenever the P/E ratio on the S&P 500’s normalized earnings reaches 20. Putting this indicator into practice is a bit tricky, since it requires normalizing those earnings – adjusting them, in other words, for where we are in the economic cycle. Nevertheless, Davis calculates that normalized earnings on the S&P 500 Index/quotes/comstock/21z!i1:in\x currently stand at “around $60”, which suggests Davis will be looking to start exiting the market at the 1,200 level.

(2) Sentiment. Davis maintains his own sentiment index, which he calls his “Crowd Sentiment Poll”. This index currently stands at 62% according to Davis, which is just above the 61.5% level he considers to be the lower bound of “extreme optimism”. He says that on past occasions when this index rose above 61.5%, its eventual peak has averaged 68%. He says reaching that level this time around would “be a sign for traders to begin selling weak performers”.

(3) Internal market divergences. The indicator that Davis relies on here is one created three decades ago by Norman Fosback, who currently edits a newsletter called Fosback’s Fund Forecaster. The indicator is called the “High Low Logic Index”, which represents the lesser of new 52-week highs or new 52-week lows as a percentage of all issues traded. Fortunately for the current market, this index is solidly in bullish territory right now at 0.8%, according to Davis’ calculations. He says it would have to rise to around 2.5% before he would start looking for the exit signs.

(4) Rising interest rates. Davis has found from his research that one of the best market-timing indicators in recent years has been the 26-week rate of change for investment-grade bond yields. With that rate of change currently standing at minus 12.6%, a sell signal from this indicator is not imminent.

Davis concludes that only one of these four indicators is even close to flashing a sell signal and he therefore gives the bull the benefit of the doubt (but in a secular bear market).

I find it difficult to pinpoint a top in a momentum-type market as we are experiencing now, but am concerned about the fact that the S&P 500 is now priced for 40% earnings growth and 4.0% real GDP in the coming year (as calculated by David Rosenberg of Gluskin Sheff & Associates). Looking at the next few weeks, I see no reason to alter my assessment as stated a few days ago: “I am of the opinion that stock markets have run away from fundamental reality and that a pullback/consolidation looks likely. Taking a slightly longer-term view, I think we are in a (possibly lengthy) bottoming-out phase as far as slow-growth (OECD) countries are concerned, but already in new (potentially volatile) uptrends regarding high-growth emerging and commodities-related markets.”

In the short term, caution seems to be in order.

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1 comment to When will the rally end?

  • Paul C Sandison

    I don’t think we are so far away, particularly if we see an excess of 1100 on the S&P during August and/or September. The present trading from March to August has been relentless but too thin. It would appear that there has been a concerted effort by institutional investors to keep their hands in and conduct regular buying by dripfeed.
    The regular nature of the steps upwards suggest the rise has been the result of calculated risk taking.

    But there is still an estimated $3.2 trillion on the sidelines in different forms. Some say far more. If the S&P 1100-1200 spike happens, then the period in and around the 23-25th September will be very interesting to watch, with possible falls.

    To compound this picture there are plenty of very difficult scenarios in Southern and Eastern European countries a pip’s squeak away from implosion. The risk of default is becoming disquieting, plus we now see sharp declines in Russian GDP.

    On the Asian side, Chinese statistical gathering is partly a dysfunctional unpurged relic from the statistical system inherited from the USSR during the communist era and not fully compatible with capitalism. The recent Chinese statistical releases are contradictory and approaching the bizarre. Two of the Chinese bubbles may well burst in the next 6-8 months – housing and credit.

    We should also remember that pumping in liquidity to save the US-UK-EU financial systems is only a pre-requisite to the repair of their economies, and is not the same thing as increasing GDP through structural change to deliver new products and secure new markets for those products.

    The present US-UK-EU administrations have largely failed to stimulate innovation of the latter, and the continuing consumption contraction can only shrink their economies further. Fiscal deficit spending of 6-8% a year to sustain consumption to prop up GDP is not sustainable, even in the medium term. I am afraid GDP growth of 2-3% in the US-UK-EU bloc for 2010 is pie in the sky.

    Lastly, a comparison with the stock market in 1929-1933. After the first fall in autumn 1929, there was one reflexive rebound and then the 1929 lows were successfully tested in 1930. After the next rise, however, the market fell past the first two lows and carried on going down.

    Much like the regular implosion of the floors of the Twin Towers on 9/11, the markets in 1930-1933 rhythmically and inexorably contracted through several levels of support in what must have been a terrifying series of free falls until 1933, three years later, when prices only came to rest on the bottom with the election of the innovator, President F.D.Roosevelt.

    This time around in 2008-2009, the order of one reflexive rebound and one testing of the lows has been reversed, no doubt because of Bernanke’s helicopters in early evidence.

    The lows of November 2008 were successfully tested in March 2009, and then came the reflexive rebound between March 2009 and now, this August 2009. So apart from the reversal in the order the pattern is the same as 1929-1930 – one reflexive rebound and one successful testing of the lows.

    In essence, having risen to these giddy heights this July- August 2009 the question for reflective investors now becomes: where are the fundamentals to back up this +50% rise?

    With this question gathering more and more urgency, until the end of 2009 many in the market may begin to understand that the highs of 2007 are not coming back, and that most of the very large economies in the world are in very poor shape or, in the case of China, taking great risks in a desperate/reckless uncontrolled expansion.

    Although the financial system has been restored to normality as far as interbank lending and commercial paper is concerned, bank lending to small and medium size entrepreneurs is still far too tight throughout the bloc. Where then is the increase in growth going to come from?

    The global scenario is still very risky. When sudden crises next appear in different parts of the world there will be no luxury of carefully planned G20 meetings a month or so in advance.

    Events may unravel very fast this time since more countries are further stretched and on the brink of failure than a year ago. Since the US-UK-EU countries do not have much of countercyclical projects under way, which quite a few emerging countries do, any new difficulties will be felt most in the US-UK-EU bloc.

    Of course when faced with deeply disappointing negative events, the risk of markets overshooting downwards is always high. If such negative events do cascade upon each other, then we may even see another Black Friday on the 23rd October and/or a Black Monday on the 26th October 2009.

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