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Breakout?
by Mark M. Rostenko
Editor, The Sovereign Strategist
November 9, 2004

Stocks surged higher last week as the S&P 500 took out its former rally high to post a new 2-1/2 year high. The dollar got hammered again, resulting in lows not seen in almost nine years for the Dollar Index. Gold broke out to a new bull market high while crude oil retreated to below $50.

Stocks displayed the kind of strength not seen in years last week in the wake of the Bush presidential victory. It seems that the “mini-bull market” is back in play. Or is it?

While last week’s action looked quite strong, let’s not forget that post-election enthusiasm is not exactly the kind of sustainable stuff that major bull markets are made of. More importantly, the action was not confirmed by the Dow and Nasdaq Composite, both of which remain far below their corresponding highs.

Earlier in the year it was a divergence between the Nasdaq and the other indices which tipped us off that the rally was likely on its last legs. This time around the divergence between the S&P 500 might serve as a tip-off that the rally was little more than a knee-jerk reaction, a relief rally of sorts.

Now before I’m accused of being a perma-bear, please understand that if the new highs are the real deal and prove themselves as such, I’m more than willing to acknowledge that I’ve been wasting my time writing bearish essays for the past however many months it’s been. In fact, I might even become a buyer. But really, there’s simply not enough to go on yet.

The S&P 500 exceeded its former rally high by around seven points. Throughout 2004 it has been trading in a massive range, making no progress overall, simply churning back and forth. Last week we saw a minor breakout, but if you’ve spent anytime on a trading floor, you know that the pros take great pleasure in probing the extremes of trading ranges in an effort to unload short-term positions and gain favorable entries on counter-trend positions. We’ve seen the downside of the trading range probed several times this year. This is the first time the upside has been probed. Is it the real deal or just some typical manipulation? Only time will tell.

Of course, range extensions aren’t always the result of greedy speculators playing games. Sometimes the market just needs to know what’s there. Stocks have tried to break down repeatedly all year long with no follow-through. If the downside isn’t bringing in activity, that market will naturally test the upside. The market’s job is to facilitate trade and the market will move in whatever direction facilitates the most trade.

But let’s not forget that the economy is no better off today that it was before GW was re-elected. Fundamentally nothing much has changed between all the time the S&P has been churning back and forth and last Thursday when it first posted a new high. Are we to believe that GW’s second term will change the economic landscape in such a way that stocks should be selling for higher than they have in years? Perhaps. I’m not going to argue with the “wisdom” of the market. But one week of exuberant upside action should be considered little more than an emotional reaction unless and until it confirms itself with sustainable follow-through.

Could it really be the next wave of a genuine bull market that began in late 2002? Sure. Anything’s possible. Let’s face it folks: There’s a lot of investment capital sloshing around the country and not a whole lot of places to put it. Reason being: exceptionally low interest rates. In the absence of good alternatives, stocks may seem like a good risk.

Stocks don’t make a whole helluva lot of sense in the face of record trade and budget deficits, a plunging dollar, record low savings and record high debt levels and decreasing corporate profits. But where else is anyone going to put their money? There’s billions out there entrusted to money managers and it’s always looking for a home. If the market hasn’t fallen in this long, can you blame anyone for taking a flyer on stocks? Taking a look at the action of the market for the past year, one feature becomes overwhelmingly obvious: stocks aren’t falling. Arguably there’s an attitude of “If stocks haven’t fallen in the face of all those imbalances, they’ll never fall. So let’s buy.”

But the fact that these imbalances haven’t caused a major problem thus far doesn’t mean they never will. You can drive around with a leaky fuel line for a long time. But the day someone tosses a cigarette butt under your car at a stoplight, you’re going to have a problem. Sometimes it takes an exogenous event to tip things over the edge.

Must I insist on the bearish view no matter how high the market climbs? No. But this game always come down to risk and reward. I remind readers that we were buyers in 2003 when the market completed a bottom and broke out to the upside. We held on for some time, until the risks began to outweigh the potential rewards. That was shortly before the S&P 500 topped out and spent nine months doing absolutely nothing. Clearly, buying AND selling were both warranted, in light of how the market behaved.

Today, I’d consider buying once again, if and when this breakout proves itself. But I sure won’t be betting the ranch on a long-term buy and hold position. While the market’s p/e is considerably below its former highs, this market isn’t exactly cheap. In fact, valuations are still at levels typical of bull market peaks. And how much upside is there given all the imbalances we’ve repeatedly discussed?

Bear in mind also that we’re only just squeaking by in “recovery” mode. It won’t take much to put us back in recession and smart guys like Stephen Roach of Morgan Stanley peg the odds of just such an event at 40% in 2005. What do we have to fight it with this time? Slashing rates from 1.75% back down to 1%? More tax cuts? In the face of record budget deficit? Yeah right!

This isn’t the early 90s when we stood on the verge of amazing new technology, after the fall of communism, boosted by the “peace dividend” and whole host of other wildly supportive factors. I remind you that we’re still in post-bubble, highly-indebted-with-a-plunging dollar America. This isn’t a recipe for a sustainable bull market.

© 2004 Mark M. Rostenko
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