Still Expecting Another Leg Up

I stand by the forecast that I first discussed in early December of a powerful intermediate term market rally in two or three legs. We have already seen the first. My continued faith in continuation rests on the following rationale.

First, history almost demands a rally. A friend recently pointed out to me that the normal bear market rally is about 20% and we have already had that. But this statistic is so wide in scope it really doesn’t tell us much. The question that should be asked is what is the normal rally after a correction of greater than 50%, such as we have had? In these rather rare instances it’s far more than what we have seen. It doesn’t have to mark a long term bottom; the gains achieved can erode over time. But the rally will have real strength while it’s in force.

As a professional trader I know it’s hard to dismiss the signs of enthusiasm for stocks that seem to be an obvious tell to stay short and expect another leg lower. Larry Kudlow has a show on CNBC every evening which, for over a year, has consisted of the host insisting the bottom is in, followed by a parade of guests he implores to be bullish and share with viewers their hot picks for making money. And yesterday while I was working out midday CNBC had Cramer and other traders, in front of an applauding, rapt audience, discussing what to buy now that the bottom is in. It’s enough to raise the contrarian instincts of the trained trader and make you consider buying puts on the entire country.

But just because people that are charged with selling soap are perennially bullish for an audience that demands optimism doesn’t mean they are not right sooner or later. Even stopped clocks tell time correctly twice a day.

Second there’s the discounting mechanism of the market. I hear traders every day tell me that the news is so horrible that the market will inevitably plunge to new lows. Folks, we’ve already had a plunge. A truly horrible plunge that I have repeatedly insisted has priced in a terrible recession. That’s what we are experiencing and it’s the reason why every time the news hits the street the market isn’t selling it. The August through October swan dive forecasted what we are seeing now. The market has moved on.

The bears’ biggest argument seems to be the market is not cheap enough and thus should go lower. In my experience using valuation to pick a market bottom will cause you to miss most rallies. PE’s are often higher at market bottoms than they are 6 months out, a reflection of earnings estimates expanding only after the market has priced them in.

There is also the argument that the market is moving to the upside on manufactured news that lacks substance and that sooner or later it will become immune to these whisps of hope. Yesterday’s announcement of the mere intention of the Obama administration to design a plan to forestall bankruptcies appeared to save the day for the bulls, rallying the market back from a trend line break that seemed to signal the next move lower was underway. But those that argue the market would be doomed if only extraneous events hadn’t intervened to stem the selling miss the point. Rather than focus on the cause of the rally they should focus on the rally itself. These rallies have happened repeatedly at tenuous moments during the consolidation of the first move off the bottom and indicate to me only one thing: the selling is exhausted and awaits only a trigger to ignite the next leg higher.

There’s plenty in the political world working against the market. Both the Bush and Obama administrations have not handled this crisis well. At least the initial TARP program forestalled a meltdown of the financial system, but it and other programs have engendered an aura of state regulated capitalism that is likely to slow the growth seen in a recovery, as the government puts its fingerprints all over the economy and gets involved in the inadvisable business of picking winners and losers. And the recent stimulus package is an irresponsible spending spree that will only grow the base line of the Federal budget and continue the disastrous course we have set for ourselves of rapidly expanding our fiscal deficit that could well sooner than later threaten the solvency of our fiat currency.

But over the short term the good news is that recessions heal themselves. We are experiencing a severe recession but it is not yet comparable to the deflationary spiral seen worldwide in the 1930’s, which was brought on more by economic mismanagement than the failures of capitalism. This might yet develop but in the interim there is a window; a window in which oversold pressures will be relieved, after which the market can come up for air and assess the landscape anew.