Unraveling Stock Market Rally

By: Paul_J_Nolte

Whether you call it a merry-go-round or a roller coaster, the ride of the past two weeks has put you right back where you started. While a rally was not too surprising, given the huge amount of selling over the prior two weeks, the markets seemed to still be trading on data from overseas rather than economic data here. For example, the huge rally on Thursday was, in part, due to tremendous exports reported by China rather than our rather lousy report on weekly jobless claims.

Our trade report indicated we imported a bit more than we exported, the question is given the generally poor economies around the world, where are all the Chinese exports going? Finally, last week we highlighted a report from Economic Cycle Research Institute (ECRI) indicating the decline in economic activity in the US. Their latest report is negative indicating the economy is slowing rather than gaining steam, and the implications for stocks are historically for negative equity returns while their indicator is declining below zero (meaning a trough has not yet been made). Could be a long hot summer on that roller coaster!

With the economic data so poor (lousy retail sales, mortgage activity slow and still high jobless claims), why did the markets rally? Like a rubber band that is stretched too far, the markets had declined rather steadily for too long and were ripe for at least a bounce. In two days of trading, on employment Friday and last Monday, the two day declining volume was over 12x that of advancing volume, the worst since the market meltdown in ’08. The last two times this metric was this bad, the markets rallied over 7% in a couple of days. So the compression of the markets early in the week was very high and investors sought out the newly created value in various stocks. Whether that continues remains to be seen and improving economic data is going to have to make that happen. Coming up will be reports on inflation (or maybe we should say deflation) and additional housing data. Of course, any adverse news from outside the US will be an influence on our markets as well.

The treasury market continues to be the safe haven investment vehicle of choice as risks to bond investors begin rising around the world. A few bond “risk” indicators are giving us concern about the overall markets. First is the “TED” spread, or the difference between the three-month t-bills and LIBOR rates. Since bottoming in mid-March at roughly 10 basis points (bp), it is now above 50bp. While high, (it was consistently over 100bp from mid-07 to early ’09), the trend higher is of concern. Also, the spread between government bonds and high yield (or junk) bonds is also widening. Both are indications that investors are willing to accept lower yields for much lower risks, which could translate into lower stock prices as well.

By Paul J. Nolte CFA
http://www.hinsdaleassociates.com
mailto:pnolte@hinsdaleassociates.com

Copyright © 2010 Paul J. Nolte - All Rights Reserved.
Paul J Nolte is Director of Investments at Hinsdale Associates of Hinsdale. His qualifications include : Chartered Financial Analyst (CFA) , and a Member Investment Analyst Society of Chicago.

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