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The Latest Stock Market Recovery Is Destined to Disappoint


A sustained economic recovery requires a turnaround in the depressed real estate market -- and that's not happening.

It is plausible that we have witnessed the final corrective countertrend rally that ended last week with the S&P 500 nearing 1,295. However, the 21-Day Put/Call Ratio is indicating a level generally associated with bottoms rather than market tops. With that stated, I am shifting my near-term target for the S&P 500 from 1,280, provided on the morning of October 4, to 1,328.

The S&P Put/Call Ratio, in spite of the rally off of the October 4 bottom, is demonstrating an elevated level of bearishness and fear in the market, although bears can point to the percentage of stocks trading above their 50-day moving average at the highest level not witnessed since 2006, registering 94% at last week's markets peak. Breadth still remains at constructive levels despite the substantial two-day give-back, wiping out the previous seven days of market gains. What can we make of this environment?

I continue to believe equities are in the second phase of a three-phase bear market. The second phase, currently in month 33, is designed to lure participants back into stocks. Although seasonality is not a tradable strategy, I believe the best way for the market to achieve its objective of gathering the crowd and seducing them back into the stocks is likely achievable through a rally into year-end, prior to beginning the final and violent C wave lower into 2012 and perhaps 2013.

The rally witnessed in October was one of the largest monthly gains on record. This fits perfectly into the nature of a garden-variety bear market rally; in fact, the 10 largest single month rallies all occurred in bear markets. I believe the 38% retracement of this current countertrend rally at S&P 1,209 down to the 50-day SMA at 1,192 shall provide an opportunity to build long exposure for the final move higher and completing the second phase of the bear market. My target for the market on a 12-to-18-month forecast remains S&P 950 to 882, which should provide support as it represents the neckline to the head and should bottom from the spring of 2009.

So what are the likely causes of continued stress on the US economy that will send equity markets toward further deterioration? As fear continues from a global perspective, investors continue to seek safety in US Treasuries. The final blow off top of the secular bull market cycle in the US Treasury market, coupled with continued contractions in the US housing market, are likely catalysts. Debt markets are on track to return 7.63% this year, the most since 2002. According to Jim Bianco, long-term government bonds have gained 11.5% a year on average over the past three decades, beating the 10.8% increase in the S&P 500.

The combination of a core US inflation rate that has averaged 1.5% this year, the Federal Reserve's decision to keep its target interest rate for overnight loans between banks near zero through 2013, slower economic growth, and the highest savings rate since the global credit crisis have made bonds the best assets to own this year. According to Bloomberg, the bond market posted its first 30-year gain over the stock market in more than a century during the period ended September 30 and is likely signaling a peak in bond prices, as witnessed by the chart of the 10-year Treasury below.

Debt mutual funds have attracted $789.4 billion since 2008, compared with a $341 billion drop in equity funds, according to data compiled by Bloomberg and the Washington-based Investment Company Institute. This signals the crowd chasing a mature move. The last time bonds outperformed stocks over a prolonged period was in 1861, leading into the Civil War. A 30-year down cycle in interest rates and the unprecedented expansion of the US money supply together will lead to inflation, likely confirmed by the rise in gold prices.

The US Commerce Department said that the US economy grew at 2.5% in the third quarter -- the fastest pace in a year, yet there will not be a sustained economic recovery without a turnaround in the real estate market. Job growth in the US will remain absent unless there is marketable improvement in the construction industry, housing industry, and real estate market. Data released in October signals this is not occurring. The median price of a new US home fell 10% in September 2011 from September 2010, the largest decline in two years. The median price on a home for resale, which constitutes 94% of the real estate market, fell 3.5% in September 2011 from September 2010, and there are 11 million homes in the U.S. where the mortgages are higher than the value of the home. These data points demonstrate there is not a housing recovery in sight.

What will happen to our economy and real estate market as interest rates rise? It is likely to keep an already depressed real estate market far from a sustainable recovery, and a fragile global economic landscape muddling through a long road toward a meaningful recovery.

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