More Upside Ahead

Today’s article comes courtesy of frequent contributor Dave Van Knapp. His site, SensibleStocks.com, is chock full of clear-headed ways to pick stocks and explains the oft-unappreciated role of dividends.

This Rally Is Sustainable

by Dave Van Knapp
SensibleStocks.com

The blogosphere is full of pundits trashing the current stock market rally. I wrote an article several weeks ago making a case for the sustainability of the rally, and I got flamed by commenters. Sentiment ran about 10-1 against me.

The day that article ran, the S&P; 500 finished at 884. It closed yesterday at 943, up 7%. Altogether, the current rally, which began on March 10, is now almost three months old. During it, the S&P; 500 has risen from 677 to 943, a 39% increase. The climb started fast, then slowed somewhat but has still kept going generally up. Each month since the rally began, the S&P; 500 has gone up: 9% in March, 9% in April, and 5% in May. The largest drawdown during the run has been 5%. I have been investing into the rally via a series of purchases of SPY (SPDRS, an ETF that tracks the S&P; 500), using tight 8% trailing sell-stops. None of the stops has been hit. All positions are in positive territory.

So is the rally sustainable, or is it a “sucker’s rally,” a “dead cat bounce,” an unsustainable secondary bullish period within a primary bear-market?

By one measure, a definition used by Ned Davis Research, it already is a bull market. They declare a bull market occurs whenever there is a 30% rise in the stock market over a 50-calendar-day period. That’s already happened.

The same organization uses an alternative definition of a bull market: a 13% rise after 155 calendar days. That has not happened yet. It has been 84 days since the rally began on March 10. But note that the increase required by the second definition is just 13%. The market could go backward from here (to 765) and still satisfy the second definition. But we’re interested in future sustainability. So for purposes of discussion, I arbitrarily tacked on the second definition to the first to arrive at a definition of “sustained” from the time of the first article. The bottom line: Will the S&P; 500 reach 1050 by October 12, 2009? That would certainly be a sustained, investable rally in most people’s minds. It would comprise a total increase of 55% since the March 9 low and a total duration of about seven months.

I think this is possible, perhaps even better than a 50-50 chance. Those who guffawed a few weeks ago have already witnessed the market achieve almost half of the additional rise needed. At 943 today, the market is less than 12% short of the 1050 target, with more than four months to get there. Will it?

There are plenty of articulate, intelligent commentators making the case that the market is heading for a major fall, and soon. But there are arguments to be made on the other side. Here are the ones I consider to be the strongest:

  • Bull markets usually begin during, not after, recessions. In talking about the market, I am emphatically not talking about the economy. The economy is staggering, with more shocks still to come. Unemployment will undoubtedly rise, perhaps to 10% or more. But unemployment has always been a lagging indicator. Charts of the last nine recessions (available here) show clearly that eight of them had bull markets begin prior to the end of the recession, about six months on average.

  • There are signs that we may be nearing the end of the recession. If bull markets start a few months before recessions end, the question becomes, are we nearing the end of the recession? There is evidence pointing in both directions, but here I am making the case for the sustainability of the rally, so I’ll focus on positive signs:
    • The Institute for Supply Management monthly survey of new orders bottomed in December, with a positive trend since then.

    • Initial unemployment claims appear to have flattened out, even as the total number of unemployed still rises.

    • We are seeing stable and rising commodity prices, with oil up more than 40% from its low and copper up more than 50%, both indicative of improved demand.

    • There are some positive signs in the still-bleak housing sector: The inventory of unsold single-family homes peaked last summer at 4.5 million units and has subsequently declined to 3.7 million. (A more typical inventory level is 2 million units.) Affordability (the ratio of median house payments to median income) is improving, and the $8,000 first-time-homebuyer tax credit is beginning to impact the market, at least at the low end.

    • The University of Michigan Consumer Sentiment Index, which fell to a low of 55.3 in November 2008, rose in March to 57.3, in April to 65.1, and in May to 68.7. The indicator has now been up five of the last six months.

    • Bernanke and the Federal Reserve are pulling out all stops to stimulate the economy. Since September 2008, the money supply (M2) has been growing at a 13% rate, one of the highest in the post-World War II period.

    • Measures of banks’ willingness to lend each other money have shown substantial improvement. The rate premiums demanded for unsecured lending between banks fell by more than 80% from their 2008 peak to mid-May. In the past couple months, several banks have successfully floated secondary stock offerings, raising capital to get out from under TARP restrictions and/or to strengthen their capital positions.

    • The Index of Leading Economic indicators rose in May for the first time in seven months.
  • Post-recession rallies can be powerful. According to Navellier and Associates, the five most recent recessions before the current one (all shown in the previous charts) each spawned powerful rallies. Working backwards in time:
    • Recession: March, 2001 to November, 2001. Market bottomed in October, 2002, then gained 50% in 17 months. (Note: This is the only one of the bull markets that did not begin during the recession.)

    • Recession: July, 1990 to March, 1991. Market bottomed in October, 1990, then gained 45% in 19 months.

    • Recession: July, 1981 to November, 1982. Market bottomed in August, 1982, then rallied 66% in 15 months.

    • Recession: January, 1980 to July, 1980. Market bottomed in March, 1980, then went up 35% in 12 months.

    • Recession: November, 1973 to March, 1975. Market bottomed in October, 1974, then gained 76% in 21 months.

To repeat, the strongest argument that this rally is sustainable is the historical pattern that bull markets start about 6 months before the end of recessions, backed up by growing evidence that the current recession is in its final months.

Anybody who claims to know whether this is a bear-market rally or the end of the bear market is blowing smoke. Nobody knows at the time it is happening. What I’ve tried to do here is make the best case for the sustainability of the rally in the face of a continuing bad economy. The jury — the investing public — will make the final call.

DISCLOSURE: Long SPY, IBM, and FDS, having moved from an all-cash position at the beginning of March to about 52% invested now. If the market continues to go up, I will continue to buy into the rally.

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