Back to the venerable Richard Russell, who said:

“The rally is running into some hesitation. Transports have been down 4 out of the last 6 sessions. When the Averages disagree, it’s often a sign of distribution. Let the market have its fun. As far as I’m concerned, the primary trend of the stock market remains bearish although the secondary trend has turned up. When a market becomes too oversold, the secondary correction acts like the ‘release valve’ in an over-heated boiler. Some of the steam escapes, and they call that an upward correction.

“Often, these explosive corrections look better than the real thing, Furthermore, they can prove costly to both bulls and bears. Corrections in a bear market are always tricky and deceptive, and I've learned not to fool with them.”

In the extreme bearish camp, Nouriel Roubini shared the following caveat emptor (via Tech Ticker, Yahoo Finance):

“Dear investors, do enjoy this dead cat bounce and bear market sucker’s rally ... don’t wait too long until you jump ship while the financial Titanic hits the next financial iceberg: You may get squeezed and crashed in the rush to the lifeboats.”

The Achilles heel of the stock market is the uncertainty regarding corporate earnings. The graph below, courtesy of Chart of the Day, illustrates that 12-month, as-reported S&P 500 real earnings have declined over 80% over the past 18 months, making this by far the largest decline on record (the data go back to 1936). “During Q4 2008, the S&P 500 came in with its first negative earnings quarter ever and the amount lost during the quarter was more than the index has ever earned during a single quarter,” said Chart of the Day.



Also, it's important that confidence be restored for the recent gains to be more enduring. The chart below shows the strong historical relationship between the US Consumer Confidence Index and the 12-month change in the S&P 500 Index. One needs to take a view on the direction of confidence, but should it for argument’s sake pick up from 30 to 40 by the end of June, the relationship indicates a S&P 500 decline of 30-35% in year-ago terms. Using end-of-quarter prices, this means an Index at between 832 and 896.


Click to enlarge

Taking one step at a time, the next hurdle is the release of potentially ugly earnings and guidance announcements in April. By then a clearer picture should also start emerging on the results of the Fed’s medicine, and whether credit markets are thawing and confidence is beginning to improve. Very selective stock picking is in order, but tread carefully otherwise.

For more discussion about the direction of stock markets, also see my recent posts Video-o-rama: Fed employs nuclear option and Technical Talk: Rally continues... . (And do make a point of listening to Donald Coxe’s webcast of March 20, which can be accessed from the sidebar of the Investment Postcards site.)