Is This Stock Market Rally For Real?

With each passing week, the case for a bearish reversal out of this stock market rally becomes stronger. For the time being, the bulls triumphed by breaking out of a potentially ugly double top pattern. This raging bullish sentiment pretty much sums up last week’s stock market actions.

The bulls are buttressed by the highest level of consumer confidence (up for three consecutive months) since last September. Investors are no longer stricken by fear with the volatility index (VIX) trending lower into the 30s.

Businesss conditions have also improved as the credit market thawed. A major indicator is the TED spread (difference between what banks and the US Treasury pay to borrow for three months overnight). It is often viewed as a measure of systemic risk in the economy and willingness of banks to lend to one another.

From a high of 465 basis points, it has fallen to only 48 basis points, near its long-term average of about 50 basis points. The return of liquidity is crucial for businesses to function and expand their operations.

Investors’ renewed appetite for risk and inflation fears have prompted an exodus from the safe haven of US dollar. In May alone, the greenback declined by about 5%. Not surprisingly, holders of US dollars and Treasuries are clamoring for higher interest rates to hold these “undesirable” assets. This does not bode well for the issuance of US debts nor its struggling housing market.

Reuters reported that surging government bond yields may spark credit crisis II, something which the Federal Reserve will try its utmost to prevent. For better or worse, we can expect more intervention from the Fed in the weeks ahead.

Stocks as well as commodities like copper, gold, silver have benefitted from the abundance of adventurous money seeking greener pastures. Crude oil enjoyed an especially good run – its biggest monthly gain in ten years’ time.

To be sure, fundamentals for the energy sector remains intact. Supply of oil is decreasing while demand is increasing. In short, the era of cheap oil is over. We need to discover more oil fields and extract them from more challenging conditions which make drillers and exploration companies market darlings.

However, I am skeptical that demand from vigorous economic activities has enabled oil to spike from March lows of $40 to $66 in a matter of weeks. Goldman Sachs is confident oil will run up higher and has advised investors to sell bearish $34 puts for oil.

Nevertheless, rising crude oil prices is a double edged sword which can harm the healthy growth of green shoots due to consumers having lesser discretionary income from rising gas and food prices. There will be more layoffs as businesses suffer lower profit margins. It is unclear how the economy will grapple with higher fuel costs.

There is also a huge supply overhang of oil being stored at sea in supertankers. This will put a ceiling on oil prices in the near term as the floating oil supply cannot be stored indefinitely (usually 6-9 months).

GDP figures are far from encouraging. There is a contraction of U.S. economy at a revised 5.7% annual rate after sinking 6.3% in the fourth quarter. Investors must have read between the lines and smelled something good there because their bullish sentiment was not dampened.

The figures released last Thursday suggested that prime fixed-rate loans were supplanting risky subprime loans and rising adjustable-rate mortgages as the force behind the foreclosure crisis. According to the Mortgage Bankers Association, the foreclosure rate on prime fixed-rate mortgages doubled last year.

For the first time, those loans made up the largest share of new foreclosures. In the first quarter, a seasonally adjusted 6.06 percent of all prime loans were delinquent, up from 5.06 percent in the last quarter of 2008.

Clearly, the worst of the housing market woes are yet to come. This time, it will come from prime borrowers which will be an immense challenge for the Obama administration as they occupy a substantial percentage of loan portfolios in most banks. We have seen how the subprime crisis wreck havoc around the world, hopefully, the global financial system is now better prepared to withstand the shock of prime borrowers defaulting en-masse. 

As the 1st quarter earning report season draws to a close, investors can take heart that corporate profits (especially the banks) have emerged from the abyss of never-ending losses. However, don’t expect to scale dizzying heights any time soon.

The stock market rally has priced companies optimistically to the point that price-earnings ratio are dangerously high. It seems that earnings are not important currently, investors are only concerned with the timing, momentum and hype.

This is the sign of speculators and a bubble forming again. While a bullish flag is being waved enticingly, it is wise to remember that technical patterns are just a guide and can change quickly in either direction.

I feel strongly about a major stock market correction but Mr Market does not consult any of us on its mood swings, thus it is difficult to pinpoint the exact moment of the rally breakdown. There is no doubt though that the bears will get the upper hand soon.

The stock market was in an oversold condition in March but since then, it has rallied furiously due to discount recovery. As a leading indicator of econmic activity, the stock market has priced in almost all the good news and could experience a long way down, if the actual economic numbers don’t add up as predicted.

It is not safe to hang around when the market suddenly realizes that it has overshoot itself, and that the trillions of dollars are not going to create miracles by stimulating demand and creating a recovery soon.

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4 Comments

Filed under Banking, Business, Economy, Oil, Stocks

4 Responses to Is This Stock Market Rally For Real?

  1. kurt

    Hi,

    Been reading your write up regularly until this, really catches my eye and concerns. As i’m a newbie in stock investing, i only narrow myself in STI ETF. Been in dilemma and self doubting over the past months, questioning if i really miss the rock bottom.

    After reading your write up, somehow or other, it did comfort me a little.

    Based on your views, when do you reckon the bubble will actually burst?

    I still waiting and waiting to come in.

    Thanks,
    Kurt

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  4. @ Kurt -

    Thanks for supporting this blog. I don’t fancy ETFs which I will try to elaborate in future posts.

    I presume you are sitting on cash which is not such a bad thing as the stock market may make a major correction and you can then buy on the dips. Patience is a virtue as I don’t know when, if it does happen at all.

    However, if you are investing for the long term, then don’t be obsessed with missing the market bottom or not. Just buy progressively into blue chips now for dividends. Some of them are still 50% or 60% off their peaks.

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