Powerful Rally Continues

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On Monday, October 3, the S&P 500 closed at 1100, the low close for the year and down about 20% from the 2011 market high six months earlier. The news, both domestically and worldwide, was almost universally bad and deteriorating. A growing number of analysts began to forecast a global recession. The following morning opened down another 2% on a continuing lack of progress with the European debt situation.

Suddenly prices turned and began a remarkable march upward through today’s S&P close at 1224, a gain of over 11% in nine trading sessions. Only two of those days produced even small declines, with most yielding gains of more than one percent. The powerful recovery rally leaves the S&P down only slightly more than one percent year-to-date.

The critical question now facing investors is whether this is the first up leg in a new bull market or merely a dramatic correction in an ongoing major decline. There are arguments in both directions.

The speed and persistence of the rise and the strong breadth that has accompanied the move argue for more to come. Negative sentiment (a contrary indicator) was fairly high when the market turned up two weeks ago. While the sentiment level suggested that some sort of rally was imminent, the readings fell short of those that typify major market bottoms. The market has been extremely responsive to news stories recently. Leaks and rumors of possible rescue efforts for Greece and European banks have provided mighty support for the rally-to-date. There is certainly potential for more of the same over the next two to three weeks.

Negative factors, however, abound. Notwithstanding occasional mildly positive readings, most economic conditions are poor and weakening. Major European banks and governments are seriously overextended. Whatever the resolution of the European crisis, the debt burden will remain dangerously large. While U.S. and European markets have surged over the past two weeks, major Asian markets have failed to demonstrate the same level of enthusiasm. Somewhat ominously, the Chinese market remains 60% below its 2007 peak, despite that country’s economic surge since then.

Additional negatives exist on the technical side. Most noticeably, volume has been weak and diminishing as prices have rocketed upward–normally warning that the rally is not the start of a major move. Firms that analyze fund flows indicate that very little true investment demand exists in this rally. So far demand has come almost exclusively from hedge funds or other short-term trading entities. Rallies rarely persist for long without true investment demand. Perhaps most discouraging is the analysis of supply and demand forces coming from Lowry Research Corp. Their measurement of buying power and selling pressure– a valuable tool since the 1930s–indicates that the broad trading range in place since early-August shows the characteristics of distribution, not accumulation.

No single factor is a perfect forecaster of future market direction. We believe, however, that the preponderance of evidence points to a major market decline having begun six months ago, which has yet to reach its bottom. The current rally is now extremely overbought on a short-term basis and will likely soon begin to decline. Whether that decline becomes simply a brief correction of a rally that will contain a second up leg or whether it marks the beginning of a major leg down to new lows is open to question. In either case, we think it unlikely that the current rally will kick off a new bull market.