The US stock market
has seen massive swings over the last year.
However it is the current rally which has most of the pund
its confounded. In this article I will review the price action and
Review: Price Action
Rebound Off November Lows
The S&P500 rallied from its lows
of around 740 in a November to a high around 944 in early January. This was a classic bounce after a big spike down, helped along by some holiday cheer and a market mentally exhausted by the actions of the previous quarter.
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Consolidation in the mid 800s
The S&P500 then consolidated in the 800s, some using the rally to lighten up their equity exposure, and the value players believing that a 45% hair cut was too good to last, especially with the new administration coming in to save the system.
The Obama Disappointment
Investors were cautiously optimistic going into Obama’s inauguration. The first few weeks of the Obama administration completely belied their hope. The Democratic Congress was out in full force swinging for their income-redistribution agenda with more taxes, and a disruptive recipe for healthcare system, the only sector of the stock market holding up. The hope balloon burst when Tim Geithner’s initial announcement about the Bank Rescue Plan turned out to be much ado about nothing.
The Sell-Off
This sell-off was particularly vicious, taking the S&P500 down from the mid 800s all the way down to 666, crashing through the November lows of 740. The pace of this sell-off with its series of one down day after another and a clean slice through support levels was vicious and in some ways unexpected.
Buyer Capitulation
The fact that this sell-off was not driven by a major shock event (like the Lehman Collapse) suggested that investors had lost all hope. Lowry Research which uses proprietary measures to capture the strength of the two sides of the market noticed an almost complete absence of buyers in the market.
The Rally
The rally was driven by some good news coming out US banks followed by a string of announcement like the PPIP (Bank Rescue Plan), the adjustments to Mark To Market Accounting Rules, review of the Uptick rule by the SEC, positive words from the G-20, and some better than expected economic data (which continues to be bad).
This psychological capitulation by the buyers was a key component which has driven this rally. Since there were not that many buyers between the 800 and 666 level, the rebound of the lows was swift since it did not encounter a lot of new selling pressure.
What is somewhat surprising is the strength of the rally after it reached the congestion area around 800 and above.
I will make an attempt to dissect the different segments of the market next and their role in the market action.
Classes of Market Participants
I would classify the market participants into three groups:
1. The Bearish Camp: This camp struck gold last year and the viciousness of the sell-off has emboldened them. They believe that this is sucker’s rally which is destined to fail. Analysis by Elliot Wave followers suggests that the final leg down of this market (the Wave 5) has yet to happen and will undercut the low of the 666 (the Wave 3). They continue to short any major move up, in spite of the six consecutive higher weekly closes in the S&P500.
2. The Mid-Way Camp: These are the group of people who are perfectly happy in not participating in the first 10% of any move from extremes, but do not want to miss out on the rest. Once S&P crossed up over the November lows, these investors have been buying every dip and providing support to the market. This money can also move out fast if things reverse.
3. The Sit-On-Hands Camp: This is the risk-averse camp which will stay in low risk investments till there is a clear sign of the end of the recession. This is the camp which is enduring
the biggest anxiety right now. The fundamental indicators are not pointing up but the stock market has rallied to 28.5% from its lows.
Short. Squeeze. Repeat.
Emboldened by the success of the past year, many shorts continue to sell any rally above 800.
However the investors in Class 2 provide the buy support whenever the market dips.
It is the Class 1 traders who are providing the fuel to the fire when the market goes up. We often see parabolic up-moves as the shorts hurry to cover after some headline causes an up-move.
This short, then squeeze cycle is repeating itself every few days, especially in the sectors with the weakest fundamentals like the Commercial Real Estate (IYR).
Can The Rally Continue?
The case for why this is a bear market rally which is bound to fail is strong, and has been made by many economists who have predicted the crisis. There is no denying that there is a lot of merit to the arguments being put forward. However unlike economic data, which always has a measurement and source bias, the charts capture what the market feels right now, and the charts have been trending up.
The market is at a critical junction right now with participants looking to see if the low volume gains and news highs of this week were just some holiday cheer or something which can hold. The S&P500 is getting close to the 870 level where it formed a double top in February. It is likely that Class 1 investors will start putting on big short positions since they see this as the ultimate top. Class 2 investors will start taking profits since this resistance line is blinking on all screens. There are reports that the short interest is edging up again after a decline in mid-March.
Global Coordinated Cheerleading
However, we are in
a news-driven market, with a positive bias. The cheerleading is coming from Washington and all other major capitals of the world where new plans to provide stimulus or bail out another failing company are announced every day. There seems to be a coordinated effort to bring an element of optimism back in to the public psyche. The current bull- run is definitely helping the cause. The Obama Administration has toned down the rhetoric about divisive issues like health care reform or tax law over haul, finally realizing that remodeling
the house has to wait till the fire in the house has been extinguished.
Goldman Sachs: Secondary Offering
We are also seeing secondary equity offerings from different companies. A lot of them are in the commercial real estate sector. However there is news out the Goldman Sachs too is considering a secondary offering following the announcement of their earnings next week. This news sent Goldman stock up $9.58 on Friday to a high of close to $125.
Typically Wall Street provides support to equities prior to secondary offerings since they want them to do well. In this case it is the Grand Daddy of them all coming in to raise money. However tempting it might be, it would not be prudent to stand in front of this train.
Banks: Stress Test Results and Earnings
We are also getting leaks that many banks are performing better than expected in their stress-tests. With changes in Mark to Market Rules, and at least a few big names like PIMCO getting on to the PPIP band-wagon (at the tax-payers expense), it is likely that the fear of imminent failure will be significantly diluted. Even Meredith Whitney, whose bearish calls have dominated the air-waves since 2007 suggested that shorts are better off not pressing their bets till the smoke clears after the earnings are out.
Historical Analysis: Long Streaks Possible
I performed a quick analysis looking at the Weekly Streaks in S&P500 using data from Yahoo going back all the way to 1950. The market has had 190 streaks which have lasted five weeks or more. And the probability of a sixth winning week after five up weeks is 0.5211 (52% chance of an up-week). Incidentally the longest weekly up streak in S&P500 is 13 weeks from March to June of 1957, while the longest down streak was eight weeks which occurred once in 1970 and then in 2001. The longest losing streak of this bear market was six weeks in July 2008.
Broader Perspective: Reduced Uncertainty
Investors should also not forget that the market was at the 870 level right before Geithner disappointed. The government, regulators, and banks have moved quite some distance forward from that time.
There is a lot more clarity on what the government plans to do, how the banks are going to be judged, and how various governments all over the world will act.
There are clear signals that the auto-makers will be forced into fix their house via some sort of bankruptcy which will involve the bond holders to take a hit, but likely put the automakers back on a firmer footing, without a major shock to the US economy.
Further, there is a glimmer of better than expected economic data which is coming out, helping build the bull case.
Though the jury is still out on whether the plans will work, there is no doubt that the element of uncertainty of what will happen, is significantly reduced and will be priced by the market. If the market could be at 870 just on hope of a plan, it can certainly reach that level or even higher without the uncertainty.
What Happens if S&P 500 Breaks Above 875?
A decisive break above the February double-top will likely bring some investors of Class 3, into the market. They can wait out a sucker move for so long. This will also force a lot of Class 1 shorts to cover.
This can send the market to a big upswing, well into the 900s and perhaps to the High of the Year around 940 or even the 1000 mark. Market tends to overshoot in either direction. If we get caught in a major running of the bulls, it is likely to overshoot to the upside again; independent of what the economists say about when the economy will recover.
What Happens if S&P 500 Is Unable To Break 875?
I believe that we will churn between 800 and 850, and a break of 800 will likely take us down to the mid 700s. However I do not expect the move to be a cascading water fall but a 2 step down with 1 step up kind of dance. Of course this does not mean that we are not going to test the 666 lows, but the pattern of the decline is unlikely to be like the decline earlier this year, at least for the next month or two.
How to Deal with This Market: Reduce Risk Margins and Hedge
My personal strategy is to reduce risk margins in my portfolio and watch my positions closely. I am not trying to make any home-run plays since there is no edge either way. Till the market shows it hand, it is time to build equity, with one single at a time.
This does not mean that you have to sit on cash. You need to have a hedge portfolio, either by having both long and short positions, or using options. Further you need to keep your losses low by using real stop loss levels; this is not a time for mental stops. Once the market shows it hands, it will be the time to press your bets.