Zeller Kern’s Weekly Investment Monitor
Market Rallies During Tough Times July 28, 2010
Currently, if you have been reading our "Weekly Investment Monitor" commentary, you are aware of what our concerns are and what our ongoing thesis is for the longer term. Let's first review this before we discuss some interesting developments within the equity markets. As we said in our "Outlook for the second half of 2010", we expect that if the "bear market" rally has not yet completed, that it may do so later this year, and could produce an alarming decline in the market. That is, if we are not already in place to do so. We expect the economy, based on current trends, to roll into a period of significantly slower growth or possibly a recession. And finally, the crisis of credit will play into the picture once again, possibly putting notable stress on the financial system. This should put further pressure on prices, on assets and bring deflation well into the picture.
We also provided you with some charts that illustrated three scenarios that we were deeming to be possible in the markets over the next year or so. Two out of the three scenarios gave an outlook of higher market prices extending into next year before the "bear market rally" finally peaked and headed into its significant decline. The other scenario, showed the S&P 500 index rallying to the 1150 level before rolling over and getting back into a declining trend. Even though our outlook is not particularly favorable longer term, we could see a rally here. We are seeing a shift within our technical models that indicate that a rally may be taking hold. As we have stated a few times this year, the market will be more challenging this year versus last year to gauge. But if certain conditions move into place within our technical models, we could see the market moving higher and extending the "bear market" rally.
Over the past several weeks we have continued to discuss the trading pattern that the markets have been locked in for the past several months. It looks like this pattern will continue with one caveat that this time we could break out of the pattern to the upside.
Though fundamentals within the stock market and the economy continue to be troubling to us, the overall pattern of the market is somewhat positive. Our more optimistic outlook that we gave earlier this year was for the market to hit 1250 and possibly 1325 on the S&P500 before the rally was complete. This scenerio was brought to an end by fears of a European financial disaster and/or double dip recession.
Well the question that has to be asked is did the stress test on the European banking system put this situation to rest. If it did then market participants have to refocus on the economy and earnings. Just like the past two quarterly earnings reports companies are making profits but their stocks are being discounted for not increasing revenue growth. We have suggested in the past that the productivity gains will likely drive corporate profits and not revenue growth. But the beauty of this situation is that if revenue growth does come back then the profits will accelerate. Nothing really has changed as this is the way it has always worked.
Since there was a massive destruction of capital during the last recession, this capital will probably not be rebuilt for 5 to 10 years, which then the dynamics will be different or a "new normal" will unfold over the years to come. The reality is that many companies are making a lot of money in this economy. And if they can make money and the conditions are right, their stocks will rise.
Currently our models suggest the markets are getting more traction as they have consolidated. But don't get too excited. As the technicals firm up in the markets, and as investors are anxious to put money back to work, the battle between the technical aspects of the market and the fundamentals of the market and the economy will continue.
As we have discussed in recent weeks, the economy is showing symptoms of weakness and possibly heading once again into recessionary territories. We refer to the ECRI index of leading indicators, which continues to deteriorate. One of the main components is the ISM services index. If the index drops to 54 or below, it is a sign that we are not headed in the right direction and closer to a recession. This index is currently at 53.8 as of last month. But, that is not the only thing that the ECRI index is comprised of; it also includes the measurement of the M3 money supply. And as Brian Hussman of the Hussman Funds has pointed out, the ECRI index, on a weekly basis has slipped again. (http://www.businesscycle.com/resources/)
The WLI dropped to a -10.5% growth rate last week. We will see how things unfold here in the future. The ISM index for July is due out Monday, August 2nd. We will see what that index looks like then.
There are many issues that can work against the stock market rising for a longer period of time. But, for now, there appears to be some strength gathering that may produce some positive results.
The Markets
Looking back on last week the markets move higher as the better-than-expected second quarter earnings reports kept a solid bid in the market. The all of the major averages ended on a strong note, moving higher Friday after the release of the European banks stress tests results.
Nine of the 10 sectors were up as market participants rotated into cyclical stocks,
as witnessed by the Industrials and Basic Materials sectors leading the way.
Once again we are also seeing the mid- and small-cap stocks outperform as the
Russell 2000 was up 6.6%.
Then there was Bernanke's testimony, as usual it created some anxiety, as his
comment that the economy is "unusually uncertain" was just one of his several
silly remarks he made during two days of testimonies.
While there is little hope for housing market the existing Home Sales showed a
smaller-than-expected decline of 5.1% as the market continues to deteriorate,
but the not as bad as expected report helped the market rally and move to new
highs on the session.
There is plenty to deal with in the coming week with a plethora of earnings and
economic reports including durable goods and the Fed's Beige Book on
Wednesday and a sneak peak at Q2 GDP on Friday.
Friday's action traded in a narrow range for most of the session and in the last
three hours the market moved into new highs for this sequence to close above
the 1100.60 level with a close of 1102.66 +8.99.
The weekly charts suggest that the upward surge will continue to test the 1131
level.