David Rosenberg: The Short-Covering Rally Is Finished, Here Comes The Leg Down

Recently departed Merrill Lynch bear David Rosenberg is out with his first report from his new outfit, Gluskin Sheff.

Not surprisingly, he picks up where he left off from his last report out of Merrill. He explains further why he believes that this big, two-and-half month runup is a sucker’s rally based on short covering in the trashiest, low-quality stocks.

The Pragmatic Capitalist offers up a big chunk of the letter:


The bulls enjoyed and the bears endured a massive 37% rally in the S&P 500 from the March 9th lows to the May 8th highs. Both in terms of duration and magnitude, this proved to be the most intense rally during this 20-month long bear market. And, the bounce has been so impressive that it has taken what was widely considered to be a massively undervalued stock market in early March to one that is now at least moderately expensive. (The FTSE All-World market P/E ratio on forward earnings estimates is now around 15x, well above pre-Lehman collapse levels and nearly double the lows for the cycle.)

Since the rebound from the March 9th lows was again led by the four sectors that led the decline during the bear phase – financials, consumer discretionary, materials and industrials – it stands to reason that this was just another counter-trend rally. What we know about history is that the sectors that led the downturn are never the ones to emerge as leaders in the next sustainable bull market.

The fact that the best performing stocks were the ones with the lowest quality ratings and with the largest short interest says a lot about the nature of this rally as well — the 50 heaviest shorted stocks tripled the advance among the 50 least shorted stocks — that its sustainability is in doubt. In other words, this was a rally built largely on short covering, pension fund rebalancing and the emergence of hope wrapped up in ‘green shoot’ data points. Technical factors ostensibly played a role too because the bounce in March came off the most oversold levels in the equity market since 1932 and the rally ended just as the S&P 500 kissed the 200-day moving average – as it has been known to do in these bear market rallies. In the aftermath of the weak April U.S. retail sales results (see more below) even in the face of the latest round of tax relief, some second-guessing over the extent of any second half economic recovery has occurred. This may have shown up in the markets towards the end of the latest rally as volume weakened as the major averages advanced. Considering that cyclical bear markets typically end 4-5 months before recessions run their course, it is imperative that the downturn ends by August to justify the March lows in the S&P 500 and the other major averages. As doubts emerge over whether in fact the green shoots amount to anything more than dandelions, it now looks as though the major averages are about to embark on the fabled retesting phase towards the March lows. (We should add that the just-released consensus forecasts published by the Philly Fed show that professional economists just trimmed their Q3 real GDP projections to a 0.4% annual rate from the 1.0% estimate previously.)

We will be watching to see whether the lows hold as they did in March 2003, which symbolized the onset of the cyclical bull phase at the time; or whether this turns out to be a violation of the lows as was the case in the summer of 2002, which represented the final severe leg of the tech-induced bear market of that prior cycle.

For the near-term, it matters little because the testing process does seem to be in place right now and this carries with it well-established investment patterns. Over the past year, we have seen four other testing phases (they all failed as the market did break to new lows). Under the proviso that the S&P 500 hit an interim peak back on May 8th at 930 (it is down 3% since, even with yesterday’s bounce), here is what the recent historical record tells us to expect (at a minimum, take profits).

• The average length of the testing phase is 53 calendar days and 38 business days (versus 45 calendar days and 33 business days for the interim bear market rallies).

• On average, the S&P 500 undergoes a correction of more than 20%.

• The sectors that led during the rally, corrected most during the selloff. This means that financials, consumer discretionary, materials and industrials should underperform in the next few months, while health care, consumer staples, utilities and telecom services should emerge as the leaders.

• Market volatility more than doubles, on average.

• Bonds rally, with the 10-year Treasury note yield down nearly 15 basis points, on average.

• The flight-to-safety during these periods means that the Canadian dollar declines (on average by 10%), while the trade-weighed U.S. dollar rallies more than 6%.

• Commodity prices decline an average of 15%, again as cyclical trades unwind.

• Corporate spreads (Baa) widen an average of more than 60 basis points; it is very important to be focused on high-quality paper during these market testing periods as high-yield spreads widen, on average, by more than 300 basis points (and keep in mind the vast outperformance, which is typical, during the bear market rallies).

• What we discovered during this process was that gold performed quite well during both the bear market rallies and the subsequent sell offs (and despite the flows back in the U.S. dollar). This may be an indication that gold is in a secular bull market.

So what works best during the retest? Health care, staples, utilities; high quality bonds; the U.S. dollar.

See Also:

  • Instead Of A Gas Tax, We Get More Expensive Cars And Deadly Accidents
  • The Doomsayers Inherit The Earth
  • California One Step Closer To The Brink

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