Beware of the Recent Rallies

By Inya Ivkovic, MA — The Financial World According to Inya columnIn a perfect world, all of the pieces of the puzzle would fall into place — macroeconomics, fundamentals and technical analysis — the holy trinity pointing to true North. Of course, we do not live in a perfect world — not even in a pale version of it. The market reality these days has too many variables skewing equations that we got so used to in the past to guide us through the minefields of investing.
Recently, markets have rallied. If we have learned anything in the past year or so, it is that short-term market rallies do not necessarily define a bullish trend. Actually, the deepest market plunges have typically been followed by the steepest reflexive rallies, which were
only then followed by often-painful corrections.Since early March of last year, the markets have gained back significant territory, and then some. The duration of that mostly-not-retested rally has pushed valuations into extreme territory, and any subsequent gains should be observed with much suspicion, focusing on how fast the laggards are catching on and whether there are any significant changes in market sentiment.Another worrisome factor can be found in the fact that most of the rallying in recent months has occurred on low volume because the only players in the market are marginal buyers and sellers. It appears as if in-house traders at big financial institutions are only playing among themselves, buying and selling stocks at whatever prices they like, inflated or not, just like a game of “Monopoly” among friends. I assume this because there is little fundamental strength to support the rallies. For instance, since the March 2009 lows, fund
rallies were about three-quarters weaker than those of the U.S. stock markets.From which direction, then, should we look for signs of trouble? What could trigger the next market correction rooted equally in macroeconomics, fundamentals and technical picture?
Unfortunately, the signs are already here in the form of sovereign credit risk, the kinds of storms that are already brewing in Greece and some other European countries, as well as variability and quality of earnings.After the world’s governments put their resources together — or rather, after the governments indebted themselves to the point of ruin — it has become clear that governments have been the primary drivers of economic momentum. However, bond investors are growing impatient with the bountiful public-sector debt, which is why the future of the recovery remains more uncertain than it ever was — even during the credit crunch.

Furthermore, the question of earnings and how they tie in to market valuations is signaling that rallies cannot last forever. Earnings per share that have actually accrued are already significantly trailing the fourth-quarter earnings trend of the S&P 500 Index. Back in late
2004, the last time that the S&P 500 was testing the 1,200 resistance level, the index’s constituents were, on average, 20% overvalued. However, in 2004, the U.S. economy had sustained employment, plenty of credit, healthy balance sheets, a strong real-estate market
and rising capacity-utilization curves in most sectors.

In 2010, after the Great Recession, which was induced by severe credit starvation and asset deflation, the U.S. stock markets are overvalued by at least 20% to 30%, yet none of the 2004 fundamentals remain to sustain such valuations. No matter how we look at it, this overvalued state of existence cannot last much longer, which is why investors would be wise not to chase performance, but to practice patience and discipline.