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Does This Rally Have Legs?

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Be mindful of attaching too much value to one- and two-day movements.

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Global stock markets rallied for a second consecutive day after the US government agreed to rescue the beleaguered Citigroup (C) and President-Elect Obama introduced his administration's new economic team. He emphasized the need for quick action to hasten an economic recovery and signaled that he may be willing to keep higher taxes for the wealthy at bay.

The MSCI Word Index has improved by 10.1% since the start of trading last Friday, whereas the MSCI Emerging Markets Index lagged somewhat and registered a more modest gain of 4.6%.

The table below shows the performances of various global stock markets over the past 2 trading days, as well as figures since the respective markets' highs and for the year-to-date (all in local currency terms).

Global Stock Markets: Index Movements (in local currency terms)

Click to enlarge


The Dow Jones Industrial Average rose by 11.8% on Friday and Monday - only the 13th time since 1896 that the index has had a 2-day winning streak with a gain of more than 10%, according to Bespoke. "In prior occurrences when the Dow had one of these rallies following long periods of declines (-30% over 200 trading days), the average returns were notably more positive. While the next day had typically been negative, over the next week and month the average returns improved significantly."

One must be careful not to attach too much value to 1- or 2-day movements, but should also be cognizant of the fact that stock markets bounced off multi-year chart support levels near the 2002 lows.

I said the following in my "Words from the Wise" review on Sunday: "Oversold conditions are bound to result in rallies from time to time (and possibly around Thanksgiving), but these should not be trusted at face value. For a more lasting market turnaround to happen, I would like to see evidence of base formations on the charts, a 90% up-day, and relative outperformance by the financial sector."

At the time of writing, no confirmation had been received on whether yesterday was a 90% up-day, but the market's volume and breadth indicators certainly were not too shabby. Although the past 2 days' outperformance of financials (Financial SPDR +18.7%) and banks (Philadelphia Bank Index +18.3%) is encouraging, it's too early to mark a new trend as far as relative performance is concerned.

I also alerted readers yesterday that I was "closely monitoring the surges in the US dollar and Japanese yen (low-yielding currencies previously used for funding risky investments), as a break of the uptrends in these 2 currencies will be a good indicator of the forced deleveraging selling starting to subside. Once this situation has played itself out, we should see a return to lower volatility levels and a return of confidence."

It is on this front that yesterday's news was quite encouraging. Both the US dollar and the Japanese yen lost ground. As a matter of fact, the trade-weighted US Dollar Index (-2.2%) experienced its worst day since 1985 - and its fifth worst day since 1970.



Adding more credence to the bounce in stock markets is the fact that consistency occurred across asset classes as oversold commodities rallied (Reuters/Jeffries CRB Index +5.4%, West Texas Intermediate crude +9.2% and gold bullion +3.6%) and overbought bonds corrected (+17 basis points in the case of the 10-year US Treasury Note yield).

Also consistent with the fact that investors have gained somewhat more confidence in risky assets is the 20% decline in the CBOE Volatility Index (VIX) over the past 2 trading days. The index is strongly inversely correlated to the movements in stock markets, using the Dow Jones World Index as an example in the graph below.



A final positive for the bulls is that the period after Thanksgiving through the end of the year has usually been a strong time for stocks. Also, according to Jeffrey Hirsch (Stock Trader's Almanac), "December is normally a banner month for stocks, ranking second [on the monthly calendar] for the Dow and S&P 500 and third for the Nasdaq."

Should the bullish seasonal tendencies hold true on this occasion, the next question is what the magnitude of the potential rally might be. The table below shows the November 4th highs and 50-day moving average levels for the major US indices, together with the increases that will be required to reach these levels. Although this is guesswork, these levels could be initial rally targets.



I remain wary of rallies as the primary trend of the market is still bearish and it may not be out of the woods yet. A reminder of the ugly economic reality can again present itself when poor earnings are announced at the start of the next reporting season in mid-January. In the meantime, enjoy whatever further upside the rally may have in store.
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