Warning: The bear market rally in equities is running out of breathing room

The equity market rally still has has some room to extend its gains, but not a great deal.

As I indicated in my weekend report before this bear market rally began, the equity market's prior oversold condition, some 32% below the 200-day trailing price average, indicated a rise back to that downtrend line. For example, the S%P 500 stock index hit a low of 666, which indicated a 32% potential rise back to the area of 875 to return the index back to its 200-day average price downtrend. As of this Friday, the S%P 500 stock index closed at 814, after a Friday decline of 17 points. While a bear market rally can overshoot on the high side, it can also undershoot.

Based on the tendency of the market to return to its 200-day moving average (after moving more than 30% above or below that average), there are only some 60 points or some 9% comfortably left in the bear market rally before the overwhelming risk of a renewal of the cyclical decline swamps the market's new-found bullishness. Can I be wrong? Of course. But, the broad array of market and economic evidence suggests otherwise.

Among the most serious risks to the sustained extension of the rally is the prospect of a continued deepening of the recession. The very few positive economic signs of late are highly suspect. That is certainly true of retail sales, home sales and durable goods orders, which are either the product of inflated seasonal adjustments far beyond those appropriate or unsustainable, temporary aberrations. The continuing decline in the economy is reflected in the decline in consumer confidence, personal income, both nonresidential and residential investment,industrial production, the capacity utilization rate, as well as the high level of initial claims for unemployment benefits. Real GDP plunged 6.3% in the fourth quarter, with declines as large or larger virtually assured in both the first and second quarters. Coming reports will create strong headwinds for the rally. The March employment report to be released next Friday is likely to include a drop in nonfarm payrolls as large or larger than the 651,000 February decline and a rise in the unemployment rate to an horrendous 8.5% or higher from 8.1%.

Perhaps even a greater threat to the equity market rally is the prospect of disappointing first quarter corporate earnings reports. Expect surprise declines in earnings from a number of key companies that will force dividend reductions and an erosion of stock prices.

The volitility index, the VIX, remains above the danger level of 40, suggesting equity market vulnerability. And while market sentiment was overwhemingly bearish before the rally began, a contrarian market positive, much of that bearishness has since been replaced with optmism, a contrarian market negative.

The equity market has already priced in a number of potential market positives that are anticipated to begin in April. These include the expected reintroduction of a form of the uptick rule and a modification of the mark-to-market requirement, giving institutions with losses the opportunity to substitute an alternative to extreme distress prices on problem assets. Thus, the announcement of those changes is unlikely to be a spur to buying.

There are unlikely to be any further Federal government announcements ahead that match the stock market positives of the details of the stimulus program, the various efforts to bail out the financial system, the Fed purchase of Treasuries and the consequent reduction of mortgage rates. These are all already in the market. Unfortunately, even with all these efforts and proposed spending, it remains an open question as to whether these efforts will be effective in stemming the recession and the credit crunch any time soon.

The equity market has benefited both from the covering of short positions (leaving a smaller underpinning of shorts still to be covered)and a shift from the bond market.That has not prevented an improvement in the bond market, in Treasuries as well as corporates. For example, Moody's cut the rating on GE Capital bonds to Aa2 from Aaa, a two grade ratings reduction, versus S&P's one grade reduction to AA+ from AAA. But, the rating reductions had been previouly reflected in the exceptionally wide quality yield spreads from Treasuries. That helps explain
why even with the ratings cut and the shift to equities, the yields on long term GE bonds have been declining from a high of 9.5% just a few weeks back to 8.125% currently. This and other distressed corporate bonds remain attractive buys with a view to declines in the excessive default risk reflected in their yields at the first realistic sign of eventual economic recovery.

A growing positive for the bond market, especially distressed credits, is a growing recognition that the rise in the price of credit default swaps, the insurance against debt default, has been partially manipulated higher by short sellers with an eye to driving equity and bond prices lower. It requires only a relatively modest cost to drive the price of a credit default swap higher, thereby creating an exaggerated impression that there is substanially more risk in that company's bonds and stocks than warranted.


Philip Braverman, President
Braverman Economic and Financial Consulting
One Hewitt Square #249
East Northport, New York 11731

Email Address: philipbraverman@Gmail.com

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