The S&P 500 is up almost 60% since March. The Dow just had its best quarter since '98.

Yesterday, the Dow slipped 29 points. Is the rally finally rolling over? Or is this a genuine bull market, just taking a pause?

If it is a real bull market, then it's a funny looking bull - one that's missing parts!

For example, corporate earnings are missing. P/E ratios are rising far above the corporate earnings that support them. This puts the market 35% overvalued, on a cyclically adjusted P/E basis, says Smithers & Co. And if you look at it in terms of its "q" ratio - a comparison of capitalization to replacement costs - the S&P is even more overvalued. As for emerging markets - "they're off the charts," says The Financial Times.

Another missing part is the consumer. This from David Rosenberg:

"Consumer confidence not only surprised to the downside in September but the Conference Board index actually fell to 53.1 from 54.5 with both the 'present situation' and the 'expectations' component failing to build on the August rebound. Before we go any further on the details, let's recall the following:

• Historically, by the time the S&P 500 rebounds 60% from the trough, the confidence index is sitting at 92.0;
• The month recession ends, the index is, on both an average and median basis, sitting at 72.0;
• During an economic expansion, the consumer confidence averages 102.0; in a recession, it averages 72.4.

"Just to put a 53.0 reading into proper perspective. It's still recessionary... The only categories [that] actually saw their confidence level rise in September were the ones in the lowest income strata - less than $25,000 (their confidence rose two points). After all, they're the only ones really benefiting from all the government intervention into the economy and the markets."

It's not hard to figure out why consumers lack confidence; this bull is lacking in jobs, too. A worse-than-forecast report came in from ADP Employer Services yesterday. It said US companies cut 254,000 more jobs in September. And Reuters reports that jobless rate rose in August in all US cities.

The bull is also missing production. Another report told us that manufacturing activity in the Chicago area is still in recession. In the United States as a whole, the latest numbers tell us that GDP fell in the 2nd quarter - but by less than forecast. "Less than forecast" might be good news if stocks were at an epic low. Instead, at current levels, it is much like a doctor who tells the family: "Thank God he got medical attention. He's dead, but not as dead as he would have been without it."

Another important part this bull market is missing is the retail stock market investor. Hey, this rally has no legs at all!

We have insisted - with no proof, up until now - that the mom and pop investor is no longer counting on the stock market for his retirement. He's seen what can happen. At the low in March, adjusted for inflation, he was back to where he was 40 years ago. That is, in real terms, he had not made a dime from the stock market (aside from dividends) during his entire adult lifetime.

We guessed that he was not buying stocks.

Now, here's the evidence: according to TrimTabs, only $2.5 billion has gone into equity mutual funds in the last six months. Bond funds have attracted 13 times as much money as equity funds, says a Morningstar report.

"US retail investors...have watched this rally from the sidelines," the FT concludes.

Wait a minute. Someone is pushing up stock prices. If not the retail trade, who? We don't know. Maybe hedge funds. Maybe institutional speculators. The pros have a different outlook. If this rally turns out to be real, and they miss it, their jobs and reputations are in danger. If it turns out to be phony, on the other hand, they risk clients' money. On balance...they are better off getting in than staying out.

But just as the pros jump like lemmings into equities...they could all scramble out fast. Give them a fright...and this rally is over.

Where might the fright come from? We can think of several possibilities. One is the housing sector. If foreclosures begin to increase...and prices fall...even the pros may put two and two together.

Likewise, a shocking unemployment number could cause them to connect the dots.

Then, look out below...

Bill Bonner
for The Daily Reckoning Australia

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If you were drawing up a plan for your dream economic recovery, this is how you would draw it up. The weakness emerging in the Australian housing sector (the fastest decline in prices in six years) would be made up for by resurgent Chinese demand for Aussie resources, led by the first growth in China's manufacturing sector in nine months.

Of course it may not be quite THAT simple. Australian data sent mixed signals yesterday. House prices fell in the first quarter despite the flood of first home buyers in the market. In fact, you could say it's the worst of all worlds in the housing market. At the low-end of the price spectrum, the grant is driving prices up, essentially wiping out the benefit of making prices more affordable. At the high end, prices are falling anyway as investors keep their powder dry (and realise that interest rate will rise again).

Prices at the lower-end of the market rare rising. "New figures from property analysts Residex show that 57 per cent of suburbs with average house values below $350,000 experienced a price increase of more than $7000 in the six months to March," reports the Sunday Age. "A similar rise was recorded in almost half the suburbs with house prices below $500,000," in the Melbourne property market.

"Average prices soared by $30,500 in Werribee South, $26,500 in Kilsyth South, and by $24,000 in Broadmeadows and Albion - all of which are suburbs with house prices at the lower end of the market favoured by first home buyers." Hmmmn.

Should it surprise anyone that housing values in these places have already grown to exceed the value of the first home buyers grant? It wouldn't surprise anyone who knows how markets (and real estate agents and mortgage lenders) work. And to be frank, state governments that generate income from stamp duty probably have no problem with higher home prices, even if the simple price inflation leaves new home buyers with a more unbearable mortgage and a less affordable home.

So how will the RBA wade into this morass of data today? It would have learned that job advertisements have fallen by 49.9% in the last year and 7.5% alone in April, according to a survey by the ANZ Group. If businesses aren't hiring now, won't it lead to higher unemployment later (which would put even more pressure on mortgage owners?) We'll have a better idea on Thursday, when the 'official' employment numbers come out from the ABS.

In the meantime, the TD Securities-Melbourne Institute Monthly Inflation Gauge says inflation is up just 2.1% in the last year. Couple that with the rise in the Aussie dollar lately as the "yield trade" is back in vogue, and you can make a pretty strong case for the Reserve Bank cutting rates when it meets today. Why?

The RBA doesn't have to defend the dollar. The markets are doing that. With inflation seemingly tame, the Bank can give mortgage owners more relief until the employment situation improves in Australia (if it does so this year, that is).

What do we think? Central Banks always overshoot in both directions. It's ridiculous to think that a small committee of men and women know exactly what the price of money and credit should be at any given moment. However, since the mandate of the bank is both price stability and growth, you can expect the bank to over-stimulate now, leading to much higher inflation later.

But really, who is worried about such things today? The S&P 500 has entered positive territory for the first time since early January. According to Swarm Trader technician Gabriel Andre in Money Morning, the Aussie market (measured by the S&P ASX/200) is now entering the second wave of a rebound rally up from last year's 48% decline.

S&P ASX/200 to Embark On Second Rebound Wave?

Click to enlarge

Source: www.moneymorning.com.au

Gabriel says wave one of the rally took the index from around 3,100 to around 3,700. It ran into resistance at 3,800. But it seems to have smashed through that this week. The second wave, he says, could take it up to 4,500. That would constitute a 50% rebound from the total decline between the 2008 high and the 2009 low.

We'll leave the technicals to Gabriel. But at the fundamental level, you'd certainly think the postponement of the government's Emissions Trading Scheme (ETS) is a breath of fresh air for the energy and mining stocks that would have been hit hardest by it. LNG producers and miners may see an especially big tailwind, especially when you factor in the idea that China's $781 billion stimulus is leading to a recovery in that economy.

So is it all over? The crash? The depression? The credit crisis?

Well, no. We wouldn't expect the banks stress tests to reveal anything at all later this week. If bad news is already priced into bank stocks, less than bad news coming from the stress tests might even lead to a rally in financials. The market anticipated that result today, driving the financials up on the S&P. And in the end, perhaps the stress test was Tim Geithner's way of forcing the banks to raise capital more quickly than they otherwise might.

But in a lot of ways, this feels like a "catch up" rally, where timid investors "catch up" with the trend buy getting off the sidelines and into the market. Or should we say "ketchup" or perhaps "catsup?" It's the kind of rally that makes things seem (or taste) better than they are (like a meat pie at the footy). And it's driven by people who are afraid of missing out on an even bigger rally.

If that's correct, then it's exactly the sort of convincing move that the insiders would ride early while selling into retail strength. Get everyone back in the game, sell for a tidy 35-40% profit on a short-term basis, then hunker down to see what the second half brings.

After all, the old trading adage is to "Sell in May and go away." It's supposedly based on the idea that the stock market generates its biggest returns between November and May on the calendar. The gap between May and the last quarter is a kind of no man's land for investors. We have no idea if that's true.

We do know that there's more than one second wave out there, though. A second wave rally in the ASX is a great time to make trades and take some profits on recovering shares. But let's not forget the second wave of bad housing debt in the U.S. (Alt-A mortgage) and the second wave of real estate losses coming from commercial property.

Those losses are going to further impair bank capital, put pressure on lending, and lead to larger declines in employment. Economies that live and die by credit growth and residential real estate still have some dying to do, we reckon. But for us the living today, the rally is something to enjoy while it lasts.

Dan Denning
for The Daily Reckoning Australia

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