Market Rally Now In Place
(March 13, 2009)
Dear Subscribers and Readers,
In my ad-hoc email to all of you on Wednesday, I observed that while Tuesday's stock market action was the most favorable since the beginning of this bear market, my inclination was to hold off on commenting on the sustainability of the rally, until I see some “follow-through” action. That said, Wednesday's action – even though the market only managed a weak rally – was still favorable net-net, as investors have tended to regard all rallies as selling opportunities over the last 18 months. The resilience of the stock market after such a strong rally on Tuesday suggests that the technicals of the stock market were indeed changing. Moreover, the continued relative strength in consumer durables (such as Whirlpool) was also encouraging, as the stock prices of consumer durables have typically been a leading indicator of both the S&P 500 and the broader US economy.
Our one-day wait paid off, as the market followed through by rallying again yesterday, with the Dow Industrials rising 3.5%, the Dow Transports 3.1%, the NASDAQ Composite 4.0%, the S&P 500 4.1%, and the Russell 2000 rising a whopping 6.5%. Breadth was positive across the board, as preliminary data showed that yesterday was again a Lowry's 90% upside day. The action over the last three days is no doubt the strongest and most positive action since this bear market began in late 2007, and is in fact significantly stronger than the rally on March 17, 2003 and immediately after – the day that marked the beginning of the four-year bull market in US and global equities. More importantly, based on our valuation, sentiment, and various technical indicators – as well as the amount of cash sitting on the sidelines – the market was much more oversold last week than at any time since probably July 1982 – a period that marked the beginning of a 17-year bull market in US stocks. For example, at the bottom earlier this week, the price-to-book ratio of the S&P 500 traded to a low of 1.2 based on fiscal 2008 earnings. Adjusting for the effects of technology and biotechnology R&D (which in theory should be capitalized on balance sheets as assets), my guess was that the price-to-book ratio of the S&P 500 was closer to 1.0, or the level that it was trading at in July 1982. Another example was the immensely oversold level in the Dow Transports. At its trough on March 9th, the Dow Transports sunk to 47.47% below its 200-day simple moving average! As shown in the below chart (straight from our interactive charts page), this represented the Dow Transports' most oversold level since March 1938, when the Dow Transports declined to a value of 19.0, or 49.50% below its 200-day moving average on March 31, 1938. These oversold readings have only been surpassed by those set during the bottom of the September 1929 to June 1932 bear market, when the Dow Transports bottomed out at 61% below its 200-day moving average! Over the next 18 months (i.e. the 18 months immediately after the bottom on March 31, 1938), the Dow Transports would rally more than 80%, despite the fact that Europe was preparing itself for World War II.
Such an oversold scenario – combined with the many positive divergences that we discussed over the last couple of weeks – suggests that the current rally is more than your typical bear-market rally. While any further strength will depend on the actions of global policy makers, investors, and consumers, the current data suggests that this could turn into at least a multi-month rally. Assuming that global policy makers continue to be aggressive in supplying liquidity and fixing the global financial system, this could even into a new multi-year bull market. Obviously, such a development is still too early to tell, as whether a sustainable bull market could arise from the current ashes of the bear market will depend on our ability to solve the US and world's biggest problems, such as the availability of cheap energy, food sources (although food supplies could improve dramatically simply if the Euro Zone adopts genetically-modified seeds for its consumption), rising healthcare costs, and a broken educational system that in no way prepares today's kids to meet the challenges of the 21st century. Only then, will our global society develop to the next stage of enlightenment and ever-higher living standards – and subsequently, to a new, and more sustainable, bull market in global equities. Thankfully, global innovation is nowhere close to dying.
I will now outline and respond two (legitimate) concerns that our readers are currently having, with respect to the sustainability of this rally.
Concern 1: The 10-day moving average of the equity put/call ratio is getting close to an overbought level (as shown in the following chart courtesy of Decisionpoint.com). Should I be worried about this?
As long-time readers should know, the equity put-call ratio simply represents another sentiment indicator that we track. It is in no way our primary technical indicator, although it does provide value as a confirmation point on our other sentiment and overall technical and fundamental indicators. With our other sentiment indicators and our technical and fundamental indicators flashing historically oversold signals (not to mention the mood of the mainstream media and both institutional and retail investors). I am not concerned with the equity put-call ratio not confirming our thesis. More importantly, neither did the 10-day moving average of the equity put-call ratio confirmed the beginning of the last bull market, as one can see from the following chart (again, courtesy of Decisionpoint.com)
As shown in the above chart (specifically, the two circles) the 10-day moving average of the equity put-call ratio did not trade at an oversold level during the bottom of the last bear market – no matter which time period you were looking at (i.e. October 9, 2002, or March 11, 2003). That did not stop the US stock market from enjoying a four-year bull market. Finally, the amount of equity options trading has somewhat declined since their peaks in March 2008 and September 2008. In particular, equity options trading volume declined further in the last few weeks – suggesting that investors are more indifferent to the market than anything else. Given the relatively quiet trading in equity options, I would not put too high a value in the equity put-call ratio right now.
Concern 2: While upside breadth and volume has been impressive in the last three days, I am still not convinced that a more meaningful rally will develop. I want to see more strength in the fundamentally strong sectors such as healthcare (as opposed to relative strength in financial stocks) outperforming before I am convinced.
That is a legitimate concern. Bear market rallies are typically led by short covering in the weakest sectors in the stock market, and obviously, the weakest sector over the last two years has been the financials. But meaningful rallies (or the beginning of a bull market) are also led by short covering anyway, and of course, buying by brave value investors. While value investors have been wrong in picking the bottoms in financial stocks for the last year or so, they may actually be right this time, as Citigroup, Bank of America, and JP Morgan have all signaled that they are on track to make a first quarter profit. Assuming the TALF is successfully implemented, both Citigroup and Bank of America should also book a profit for 2009, net of any further write-downs (or write-ups!). Compared to the plight of financial stocks a couple of weeks ago, we have come a long way. As I have mentioned before, there are no “gurus” in the stock or financial markets. Folks who have been predicting an Armageddon scenario for the banks in the first quarter and ultimate nationalization are now being proven wrong. Again, assuming the TALF is successfully implemented, there is good reason to believe that the large banking and diversified financial stocks bottomed earlier this week. If so, then a strong rally (or relative strength) from current levels is not a cause for concern. Moreover, subscribers should keep in mind that the financial sector is a unique sector – as it represents the lifeblood of the modern economy. That is why bull markets have typically been led by the financial sector.
Specifically – instead of relative strength in the healthcare or industrials (net of GE Capital) sectors – I would prefer to see widespread strength in all the sectors on any further stock market rally. This will be a good indication that defined benefits pension funds, endowments, foundations, and sovereign wealth funds have started buying again. And believe me, it is just a matter of time. From what I understand, many endowments, foundations, and pension funds have been holding off on rebalancing into equities until volatility has died down or the credit markets start to thaw again. A successful implementation of the TALF (scheduled to come online on March 25th) will go a long way toward thawing out the credit markets, and will surely entice a significant amount of institutional money to flow back into equities once again. Subscribers please stay tuned.
Henry To, CFA