What Happens After the Stock Market Rally?

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Global markets continued their relief rally overnight. The excuse this time was: better than expected US economic growth in the three months to June 30.

But it’s just an excuse. As I pointed out yesterday, the market generally puts in a rally for a few days after a precipitous drop…no matter what the news. Market commentators just latch on to whatever data release they can, to justify the price action.

Whatever. Ignore it. This is just how the market works. After this rally peters out, which it will, it will fall again and retest Monday’s lows. The point to keep in mind is that the Dow (a proxy for US markets) is in a downtrend. So the path of least resistance, for now at least, is down.

I pointed this possibility out in The Daily Reckoning back on 27 July, with the Dow on around 17,500 points. I wrote how the moving averages on the Dow were about to cross, signalling a change in trend.

Throughout 2015…the Dow Jones index has struggled to maintain its upward momentum. Now, the 50-day MA is about to cross below the 100-day MA, indicating a potential shift in trend.

That doesn’t mean a nasty bear market is upon us. But it does mean the market’s relentless rise may be over for the time being. The next important area to keep an eye on is the 17,000 point level. If the index breaks below here it will show a ‘topping out’ formation and the bears will begin to growl.

From there, it will be a question of how long the Fed maintains its tightening rhetoric. Since 2008 the Fed has shown a willingness to support the market in the event of any sell-offs.

It will probably do so again if the Dow begins to break down to lower levels. But can the Fed continue to stave off the bear? Pumping more money into the system is good for stock prices, but it can’t really reverse the business cycle or improve company earnings across the spectrum.

Let’s have a look at the Dow now. As you can see below, the moving averages crossed in late July, which signified the start of a downtrend. Of course it didn’t warn you of the massive sell-off that was about to happen, but it did tell you to exercise caution.


Source: StockCharts

Now, you’re seeing the rally take the Dow back towards the moving averages. It simply stretched too far on the downside. But now the market is in a downtrend, which suggests you’ll see selling pressure again soon enough.

While the downtrend is the dominant force right now, it’s important not to get too carried away here. The bears are enjoying this sell-off…and why not, they’ve taken a beating over the past few years. It’s time to gloat. And although I’m of a bearish predisposition, I’m taking an agnostic view when it comes to the market.

That is, absolutely anything can happen. Markets may have bottomed last week, or we could see further falls ahead. All I know is that with both Aussie and US stocks in the formative stages of a downtrend, you need to be cautious. This is not a time for brave buying of the dip, or panicking about massive sell-offs to come.

It’s a time for cold observation of the price action combined with a solid understanding of the fundamentals, and being flexible in your expectations. More importantly, you need to have a plan — and a process — for when to get out of stocks.

When it comes to the fundamentals, while stocks are overvalued (especially in the US), I still don’t see any signs of major systemic stress yet. That is, this sell off in the market is not yet pointing to any problems with the financial system. At least not in the same way that warning signs about the 2008 crisis popped up in 2007.

I looked for these signs in the 31 July edition of The Daily Reckoning, and found none.

So right now, you have to conclude that there are not too many signs of stress, although emerging market stocks do look a bit iffy.’

Indeed they did. Soon after I wrote that, emerging markets collapsed. The sell-off this week saw emerging market indices (priced in US dollars) fall to their lowest level since the financial crisis.


Source: StockCharts

This is a nasty development. Emerging markets make up around 50% of global economic growth. If the big fall in share prices warn of a major economic slowdown, it will have an effect on developing economies too.

It will just take time to flow through. But that still doesn’t mean you’ll see a systemic crisis and a GFC MK II type of event.

Something that ties in with all this emerging market weakness is China’s ongoing dumping of US treasury bonds to support its currency. This dynamic is still in its early stages, but it has the potential to be a very big deal for the global economy.

It’s a complex issue, so I’ll leave it ’til Monday to write about in detail. But for now, keep in mind that China is offloading US treasuries in a reversal of a trend that has underpinned the global economic system for the past 15 years. Trend reversals of such magnitude rarely go smoothly.

And where China is involved, Australia is not far away from the fallout. I might be agnostic on the market, but I’m far more convinced that Australia faces a much tougher economic future than most people, maybe even you, realise.

Yesterday’s capital expenditure data release was the weakest since the 1991 recession. And there’s no respite on the horizon as the mining investment boom will continue to wind down in the years ahead.

But that’s just one of Australia’s many looming problems. If you want the whole litany, and want to know how to prepare for it, keep an eye on your inbox tomorrow. We’ll be sending you details about how to claim your free copy of Vern Gowdie’s new book The End of Australia.

Regards,

Greg Canavan
Editor, The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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