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Why Rallies Fail
07/15/2009 8:30 am EST
Which seems strange, doesn’t it? After all, even after the March rally, by June 12 the Standard & Poor’s 500 Stock Index was still 40% below its October 2007 high.
And it’s not like there isn’t plenty of fuel stored on the sidelines. The total deposited in money market mutual funds hit $3.71 trillion for the week ended June 19, according to the Investment Company Institute.
With stocks still so far below the 2007 high and with all this money sitting on the sidelines, readily available for buying stocks, why didn’t the stock market just keep on running?
- Supply of stock is soaring. U.S. companies raised $259 billion by selling new shares in the second quarter of 2009, according to Dealogic. That’s three times the amount of new stock sold in the first quarter of the year. U.S. banks led the way, raising $89 billion by selling stock in the quarter. The 92 deals in Q1 were the most ever done in a 3 month period and the dollars raised were the most in a year. Also: corporate America isn’t done deleveraging so investors can expect more supply to flow into the stock market whenever higher stock prices convince company CFOs that it’s a good time to raise cheap capital.
- Demand fell as stock prices rose. The best lack all conviction. And the rest just want to take profits. Company insiders, who in theory know more about the real prospects for their companies than outside investors, started to sell as prices climbed. Citing filings of Form 4 with the Securities and Exchange Commission, TrimTabs Investment Research reports that insiders sold $2.9 billion in June. That’s almost 10 times more than the $300 million they bought. Insider selling in June was the highest since November 2008. In the last 60 days, TrimTab calculates, insiders bought just $1 billion in stock. That’s the lowest level of insider buying since November 2004. You didn’t have to be an insider to take money out of the market in June, however. The amount in money market mutual funds stocks climbed by $34 billion in the week ended June 19 from the prior week. You could vividly see the waning of enthusiasm in the volume figures too. For a rally to have legs, more investors need to buy, driven by the desire not to miss out on gains, as stock prices rise. When volumes fall as prices go up, it’s a clear sign that the rally is running short on buyers. In April and again in May daily trading volume on the S&P 500 index was always above 40 million and would occasionally brush 80 million. Starting in June, however, volume dropped until it was almost always less than 40 million and the biggest day was a mere 53 million.
- Economic data didn’t turn more positive to support the rally. The ambiguous economic forecast that was positive enough to get investors buying when the S&P 500 stood at 677 on March 9 stayed just as ambiguous while stocks climbed to 946. Let me just take a single day, July 2. A reader perusing the headlines in the Financial Times over breakfast that day read “Data show evidence of global recovery.” At 8:30 that morning, however, the U.S. Bureau of Labor Statistics released its report showing that non-farm payrolls have fallen by another 467,000 in June. That was well above forecasts for a decline of just 367,000. Adding to the gloom, average weekly hours worked by those still employed fell to 33.0 from 33.1. Not surprisingly the S&P 500 dropped 2.8% that day to 897.
So where do we go from here?
Sideways most likely.
All that cash sitting on the sidelines is still looking to get in—at lower prices. A lot of investors weren’t in stocks for the 40% rally from March 9 through June 12. They kept waiting for the correction that never came before buying. A 10% correction in July—and as of July 13 the S&P 500 was about half way there with a 5% decline from the June 12 high—would bring some of this cash into stocks. Think of that $3.7 trillion in cash as an insurance policy against a big drop in stocks.
But stocks aren’t likely to go a whole lot higher than the peak they reached on June 12 without some resolution to the uncertainty that surrounds the economy.
Look, if we’re going to have a V-shaped recovery, as Christine Romer, head of the Obama administration’s Council of Economic Advisors said recently, where economic growth takes off like a rocket from the bottom and never looks back, then stocks at 15.6 times projected 2009 earnings and just 12.2 times projected 2010 earnings are cheap. Back up the truck and load it up.
But if we’re headed for a W-shaped recovery with a big drop in economic growth in 2011 when the current stimulus package is no longer stimulating anything, then stocks as a whole aren’t especially cheap. At past bottoms investors could pick up stocks for just 10 times earnings or even less.
And, of course, there’s still the possibility that we’re not headed for any kind of a real recovery at all and that, instead, the economy is going to simply bump along the recent bottom.
What do you do? What am I going to advise you to do in the months ahead—that is in the short term--on this blog?
While we wait for the economy as a whole to declare its intentions in unambiguous language I’m going to focus on finding a few individual companies—and stocks—that have unambiguously turned the corner. Call them early bloomers. Or special situations. Whatever. These companies do business in privileged niches where demand has remained strong or is clearly coming back after a catastrophic drop-off. These are the companies that have been best at plotting a safe strategy through the Great Recession or who have been most aggressive in changing course when past strategies no longer worked.
You'll find an entry on one of these stocks, Qualcomm (QCOM) and my "buy" recommendation later today on this page.
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