Rally…But for How Long? Weekly Market Blog 01/04/09

January 4, 2009 · Posted in Weekly Posts · 1 Comment 

The last week of the old year and the first day of the new finally saw a rally in world equity markets. As readers know, I have been anticipating this rally for some time. At issue now is what the character of the move will be.

First, let’s review the backdrop: World equity markets are down 40% to 70% from their peaks. The US market is now up about 24% from it’s low. The US market has risen in the face of continuing bad news and in the face of end of year tax selling – all to the good.

The counterpoint is that we fully expect substantially more bad news is coming in 2009. Specifically, as I discuss in my 2009 Forecast, rising corporate credit defaults and rising unemployment coupled with bond yields running up and the dollar selling off sharply will be the backdrop for 2009. That said, this is a bear market rally. It will fail, likely abruptly, and the market has a strong chance that it will then go on to make new lows this year.

The S&P broke overhead resistance Friday and moved nicely above that resistance level – but on low volume. The volume is not surprising for two reasons. First, bear markets typically have lower volume than bull markets – a phenomena that contributes to the oversized price moves they can exhibit. This is something we hope to use to our advantage. Second, many players were still on the sidelines as many took Friday off.

The first few days of this coming week will tell the tale. If we see volume increase appreciably and if we see price action that indicates backing and filling, (some days up, then some profit taking, followed by renewed upside), then this rally could last for some weeks. If, on the other hand we see a rapid spike type of movement – irrespective of volume, than we can expect this move will last a few days to a very few weeks and then end abruptly.

Keep a close eye on the daily and hourly action. I believe we have a good chance of getting back to the 1000 level on the S&P. Expect some resistance there as we have flirted with that level in the past couple of months only to fall back.  If money comes in fast then we could easily spike well above that.

Look for a day when we have a price rise that is substantially out of the norm for this rally. For example, we have seen rises of the 0.5% to 3.5% level. A 4% or 5% day wouldn’t be abnormal. An 8% or 10% day would make me think we may be nearing the top. Any gap-up at the open can also be indicative of nearly the top. The key to getting a spike up will be when enough investors or funds decide that they are afraid to be out of the market and jump in so as not to miss the move. That is why it would be beneficial for a slower start to the move this week than a fast start – it would tend to entice people in.

What is likely to kill this rally? Clearly, the market has shrugged off rising unemployment; manufacturing contraction, continue falls in house prices, a gas dispute overseas, and the Israeli incursion into Gaza. So the market will spook when something it hast discounted comes along.

Some possibilities to watch out for:
1)    Anything that could impact President Obama personally. The nation is putting a lot of belief on this man’s ability to succeed. The markets will react negatively if any threat to him emerges.
2)    Corporate defaults. The equity markets have not yet factored in the high probability that corporate debt defaults will be the big story this year.
3)    Evidence that inflation and not deflation is the real problem. Readers now that Murdock Global Insight believes that the policy actions the Fed and Treasury are taking will yield massive inflation and a precipitous drop in the dollar. Any hint of inflation or sign that interest rates are headed up will shut down any rally quickly.
4)    Evidence of capital flight by foreigners. This is probably a few months off but if evidence surfaces sooner that foreign money is leaving that will throw the bond market into a panic, which will send interest rates up and impact equities.
5)    We also do not know what the funds maintaining a bearish posture will do. Though I expect most have closed their short positions last year, there is some point in the coming rally that will be seen as advantageous to short again – indeed, we will be doing the same!

Investors who rode the crash down should use this rally to build cash – preferably to get out of equities entirely. Investors who, like us, bought in at the height of the chaos in October should be looking to book profits in the next few days or weeks. Do not chase this rally up. If you are in, stay in until you take profits or raise cash. If you’re out stay out or look for evidence of a peak for purposes of shorting.
To summarize, our baseline scenario is for a sharp bear market rally, which we believe has started, coupled with a slight increase in bond yields as money re-distributes. The dollar will stay in a trading range during this time. As the rally fails interest rates will head down as money again rushes into bonds. This will be assisted by the Fed buying treasuries with the money they are printing as part of their “quantitative easing” strategy. As our nation’s fiscal position is seen to be worsening against a backdrop of a worsening economy, inflation will rise showing that it and not deflation, is the real enemy. Bond yields will begin rising inexorably and the dollar will drop inexorably as money flees the country.

At each of these stages there are opportunities for nimble, globally focused, informed investors.

As for our personal positions at Murdock Global Insight – no change this week from last.  We note that the Australian dollar has broken out to the upside. Those who went long the AD when we did stand to gain.

Kel Murdock
01/04/09
St. Louis

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