Why The Rally Has Been Sustained

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.

Why The Rally Has Been Sustained

by Dave Van Knapp

This article is a follow-up to my article, This Rally Is Sustainable, published in Jason’s column on June 2, 2009. At that time, the market rally was almost three months old and the S&P; 500 had risen from its March 9 closing low of 677 to 943, or 39%. It is fair to say that most commentators thought the rally was unjustified — claiming it had no fundamentals to support it — and that a backwards slide, or even a crash (“retest of the March lows”) was both inevitable and probably imminent.

That’s not what happened. Almost three more months have passed, and the index stands at 1029, or 9% higher, for a total gain of 52%. The rate of ascent has slowed, but overall the rally has been remarkably consistent: +9% in March, +9% in April, +5% in May, flat in June, +8% in July, and +4% in August. If you define “correction” as a 10% pullback, there has been no correction along the way.

The case I made for the sustainability of the rally has held up. Basically, I suggested that, (1) the stock market tends to rally significantly a few months before the ends of recessions, and, (2) various news items and data points could be interpreted by reasonable people as demonstrating that the recession was ending.

I’d like specifically to address those who say the rally is unsupported by fundamentals. I believe that this rally has been fully supported by fundamentals, although I suspect many will disagree with how I define “fundamentals.” Here is my reasoning in three easy steps:

First, too many investors, while recognizing that both the stock market and the economy run in cycles, believe that the cycles are concurrent. That is, they think that the stock market’s value and economic fundamental values are always directly proportionate. They are not. There are often stretches when the market’s cycle and the economic cycle are out of phase. That has been consistently true in recessions. In eight of the last nine recessions, the stock market has anticipated the end of the recession by an average of about six months. The market displays its anticipation by going up. I simply postulated that this time it would happen again. It has, making it now nine out of the last ten recessions that the market has made a significant increase during the recession.

Second, then it is reasonable to define fundamental economic metrics as “improving” if they are getting worse at a slowing rate. Such fundamental economic measures as the GDP, employment rate, consumer confidence, the Conference Board’s LEI (Index of Leading Economic Indicators), reports from ISM (Institute for Supply Management), housing prices, credit availability, and the like, do not have to be actually going up to be “improving.” They may still be dropping toward their eventual trough — the economy may still be contracting — but the important observation is that the rate of contraction is slowing. If that is happening, then you can reasonably infer that the recession is in fact reaching its late stages. By definition from the National Bureau of Economic (NBER), which has quasi-official status in such matters, a recession ends when the economy stops contracting.

Third, what I call the “net news flow” has been kicking out many data points for months now that economic fundamentals were in fact getting worse at a slowing rate. In the past couple of months, a few of the fundamental economic measures have reached individual inflection points and actually started to rise. For example, the LEI have been going up for four months. More recently, housing prices (as measured by the Case-Shiller Index) have stopped falling and are rising in some metropolitan areas. Of course, the news is often lumpy and seemingly contradictory. That’s life and is why I call it “net news flow.” The point is that the “average” of all the economic news, taken as a whole, has been going in the right direction since this rally started.

That is why I believe that this rally has been fully supported by economic fundamentals. As you can guess, I disagree with the critics of “green shoots.” The market runs on investor sentiment. It is the green shoots that have fueled this rally, giving hope to investors who have bid up stock prices in the belief that the economy first pulled back from the abyss and will begin getting better soon.

I invested based on this reasoning. I maintain a publicly published Capital Gains Portfolio, a demonstration portfolio for purchasers of my book, Sensible Stock Investing, that is also available for free viewing by the curious. The portfolio was entirely in cash for many months before this rally began. But in April, I began cautiously purchasing into the rally, mostly through a series of purchases of SPY (SPDRS, an ETF that tracks the S&P; 500). At the time of the earlier article in June, the portfolio was 52% invested. Last week, I made my final purchase. The portfolio is now 100% invested.

In addition to the cautious, gradual re-entry into the market, I’ve helped manage risk by using tight 8% trailing sell-stops. None of the stops has been hit. All positions are in positive territory. Because of the gradual investments, the portfolio’s performance this year is a bit behind the S&P; 500’s. That’s OK. Because the portfolio was in cash for so long, it did not suffer from much of the crash that preceded the rally, so overall the portfolio is way ahead of the S&P; 500 benchmark index since its inception. Risk management is very important; it helps you avoid “sucker’s rallies,” “dead-cat bounces,” and just plain being wrong.

Where is the market going from here? I haven’t given that much thought, to be honest. Now that I am fully invested (no new money goes into the portfolio other than dividends it generates), I have no more decisions to make for a while. My exit strategy is already in place via the sell-stops. Sure, I may play with the stops (tighten them, loosen them, or use a moving average rather than a flat percentage to set them), but I do not need to anticipate the market’s next major move. Past readers of my articles may recall that I believe in “waiting for the turn” anyway.

That said, I think that strong arguments can be made for at least three scenarios:

  • The market will make a correction (that is, contract by more than 10%), then resume its expansion if the news warrants it.

  • The rally will continue for some more time, without a correction, anywhere from a few weeks to many months, depending on the news flow.

  • The rally will end and the market will reverse and begin to contract. This is what I think will happen if/when the net news flow turns negative. So if, as many believe, we are in for a double-dip recession, signs of that will show up in the news flow, and the market (again leading the economy) will anticipate that and go backwards.
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