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Six Reasons for a Fall Rally

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It’s been ugly for equity investors.

Gluskin Sheff’s David Rosenberg reminds us that this was the worst August since 2001, with the S&P 500 and the Dow both falling more than 4%. The Nasdaq was clobbered 6.2%. It was the first losing August in five years. Roughly $700 billion of “paper wealth” vanished.

As we now kick off September, history would suggest few reasons for optimism. We noted in our recent article - September: A Merciless Month for Mr. Market? - the S&P 500 has posted its worst monthly return in September whether you go back to 1990, 1970, 1945, or 1928.

Some market pros, though, say there are reasons for bulls to buck. MKM’s Michael Darda, for one, believes the conditions have fallen into place for equities to move materially higher this fall.

Herewith, the man throws down his six reasons for optimism:

Commodity prices are recovering after a spring slump.
The JOC-ECRI Industrial Metals Index (which peaked on April 19, before the S&P 500 topped on April 23) has rallied 18.4% from the June 8 low.

Chinese equities are rallying after a year-long bear market.
The Shanghai SE Composite Index peaked in August 2009 well before the S&P 500’s April 2010 peak. Chinese equities fell 32% between August 2009 and July 2010, but have rallied 11% from the lows established on July 5. Recent macro data out of China suggests a soft landing (not a violent collapse) is underway.

Short-term funding spreads have narrowed markedly after a spring spike.
After a surge upward between March-June, short-term funding spreads (two-year swap, commercial paper and TED) have compressed markedly.

Investor sentiment (a contrary indicator) has collapsed.
The weekly AAII poll of “bullish” investor sentiment has collapsed to the lowest levels since March 2009, just before the S&P 500 established a major low.

Equity earnings yields are historically high relative to corporate bond rates.
The ratio of the S&P 500’s forward earnings yield to the Baa corporate bond rate is at the highest level in 30 years. On a NIPA-equivalent basis, the gap between equity earnings yields and Baa bond yields is the largest in nearly six decades.

Financial conditions have become more supportive of growth after deteriorating in the spring and summer.
After deteriorating sharply between April-June, financial conditions (BFCI Index on Bloomberg) have improved markedly. We believe the tightening in financial conditions this spring (and the dislocations from the phase out of the homebuyer tax credit) triggered the summer slowdown. Financial conditions tend to lead GDP growth by one or two quarters and suggest that the trough growth rates for 2010 should come around Q3 with growth improving in Q4 and into 2011. The improvement in the Fed’s Senior Loan Officers Survey (which shows that lending standards are beginning to ease) suggests some recovery in the credit and monetary aggregates next year, which should be associated with faster growth.
POSITION:  No positions in stocks mentioned.