Investors wise to view rally with skepticism

Since U.S. equities markets bounced off the July 15 lows, they have delivered in just six sessions a return that in less turbulent times investors would be happy to earn over six months or more. That raises the question of whether the rally is for real.

The answer according to several strategists appears to be no. Enjoy it while you can, but don't expect it to last as it is just a bear market rally.

The Standard & Poor's 500-stock index has climbed 5.5 per cent since that fateful Tuesday and the blue-chip Dow Jones industrial average by 6.1 per cent buoyed by what Myles Zyblock, chief institutional strategist at RBC Dominion Securities Inc., has described as "the biggest short squeeze" he has ever seen. The tech stock laden Nasdaq Stock Market composite has risen almost 5 per cent.

(Investors betting that a market or stock will fall sell short, hoping to buy back in later at a lower price.)

Several factors set in motion the abrupt swing from selling pressure to a "buying panic" in the U.S. market, including the announcement of a crackdown on so-called naked short selling in major financial firms by the U.S. Securities and Exchange Commission, Mr. Zyblock suggested in a report yesterday. With naked short selling, unlike regular short selling, the short sellers don't borrow the stock they are shorting.

In addition, a few regional banks released better-than-expected results and the runup in oil - which had pushed prices as high as $147 (U.S.) a barrel on July 11, spawning concern about the global economy's ability to withstand the resulting strains - has shown signs of abating. Crude has now fallen six of the past seven sessions to stand at $124.44 at the close of trading yesterday in New York.

The fact that the market has become oversold also helped.

Mr. Zyblock thinks this rally in the bear market that began in October probably has more to go, with the S&P 500 rising possibly to where the 200-day moving average comes in at, which currently is 1,384.

"If it breaks above that, then something more important might be going on," he said.

Vincent Delisle, strategist with Scotia Capital, also characterizes the recent strength in the market as a bear market rally, which he thinks could take the S&P 500 toward 1,350. He recommends investors exercise caution until the banks ease their lending standards and economic and market confidence rebounds.

Among the big winners in the rally has been the battered financial sector. Mr. Zyblock believes the heavily shorted sectors such as financials and consumer discretionary are likely to continue to lead the rally, but he downgraded the financials to underweight from market weight earlier in the month. (He has the consumer discretionary sector as a market weight, noting that group has the strongest inverse relationship to the direction of oil.)

In his report, Mr. Delisle pointed out that the selloff in U.S. financials this time around was greater than that during the savings and loan crisis when U.S. financials lost more than 44 per cent of their value between September, 1989, and October, 1990.

He regards the rally in the financials as a rebound from extreme oversold levels. "Relative earnings momentum needs to drastically improve before fundamentals dictate a resounding buy on U.S. financials," he said. The same is needed before market leadership shifts decisively from oil to financials and equities generally.

Even after the rally, the S&P 500 is still down more than 18 per cent from its high in mid-October.

Normally, the U.S. market is higher 12 months after the U.S. Federal Reserve Board starts cutting interest rates, rising 9 per cent on average. But this time around, the index has dropped 15.6 per cent since Sept. 18, which makes it one of the worst performances in 50 years following an initial rate reduction, Mr. Delisle noted.

So what would be needed to transform this rally into a new uptrend? Mr. Zyblock lists three factors: a bottoming in the outlook for the U.S. economy, a stabilization of the situation in the U.S. financial system and a break in crude prices. The last factor is already happening, which is great news for most of the equity market, he said. However, indicators such as the Conference Board's index of future economic activity released earlier this week are still declining. And there are still lots of stress in the financial system.

The S&P/TSX composite index has also risen over the past six sessions, but the increase here at just 1.2 per cent, is anemic by comparison because of the impact of lower crude and gold prices on the Toronto market.