Are We Looking at a Stock Market Rebound, or Just Another Bear Market Head Fake?

For many investors, the last 12 months have felt like a cross between Dante’s “Ninth Circle of Hell” and Mr. Toad’s Wild Ride.
Even so, after Tuesday’s market action - which saw the Standard & Poor’s 500 Index rebound from a 12-year low to gain 6.4%, and the Dow Jones Industrial Average jump 5.8% - many investors are no doubt wondering if it’s time to pile in.

It could well be. But then again, it just as easily could be a precursor to another financial drubbing - the kind of bear-market “head fake” thatI’ve correctly warned investors against on a number of occasions during this financial crisis. Given that perspective, I continue to believe the game we’ve been forced to play as a result of the credit crisis is still far from over.

In short: One day does not a rally make.

And that’s why Tuesday’s almost-euphoric run-up in stock prices seems less like a testament to savvy bailout strategies than it is a revelation of how desperate investors are right now for any glimmer of hope. The notion that a single bank - even if it is Citigroup Inc. - could single-handedly cause this kind of an upside rout on a leaked note from its embattled CEO is absurd.

For a true rebound to take place, two things have to change. The first is sentiment. And the second is business conditions. When it comes to igniting a truly sustainable rally, history demonstrates time and again that those two catalysts go hand in hand.

That’s not to say we couldn’t see a rally of 20% or more from here, or that this mini-rally couldn’t last for a while. Bear-market rallies have a nasty habit of doing that just long enough to draw in additional investors, only to chew up their money and leave them with big losses when the rally rolls over.


Bear-market rallies are actually more common than most people realize and the one we experienced late last year is a great case in point. It started on Nov. 21, and advanced a total of 20% in the subsequent seven weeks. Then it headed south again.

Obviously, I don’t know everything and I expect I’ll hear about it if I’m wrong here. But in a market as unpredictable as this one, and with the insights I wish to share with you, I am less concerned with short-term rallies than I am with long-term investing success. That’s why - if you’re thinking about getting in right now - I urge you to first carefully review both sides of the argument.

Five Reasons This Could Be a Bear Market Rally

In the “no-way-this-is-real” department:

• Major institutions - such as Bank of America Corp. (BAC), JPMorgan Chase & Co. (JPM) and Citigroup, among others - are functionally insolvent. While Citi CEO Vikram Pandit’s leaked note revealing that Citi has achieved two months of profitable operations may conform to generally accepted accounting principles, supposedly so, too, did the trillions of dollars worth of derivatives the banking giant accumulated. Show me $45 billion in government aid and I’ll show you a good time too. Nobody ever went broke on accrual accounting. Show me the cash and perhaps I’ll change my tune.


• The credit markets remain substantially locked up. According to the U.S Federal Reserve’s January survey of senior loan officers, 60% percent of domestic banks reported reduced demand for commercial and industrial loans. That’s up fourfold from the October survey, when only 15% of banks reported reduced loan demand. Even now, the banks and players like American International Group Inc. (AIG), which have accepted - in some cases, begged for - billions in taxpayer aid are refusing to detail just where the money went. For now, though, the closely watched London Interbank Offered Rate (LIBOR) is trading at its highest levels since Jan. 8 - and, in case you don’t recall from past columns on the subject, the higher the LIBOR rate that banks charge each other, the tighter credit markets actually are. If you take all of these bits of evidence together, it hardly makes a case for a healthy financial system. In my mind, the real proof would be when financial institutions willingly wean themselves from the central bank’s IV hookup.


• Hedge funds are still selling. In times of business expansion and real recovery, hedge funds buy like there’s no tomorrow. Yet, for the most part, these stealthy operators are still swamped with redemption requests and a cycle of forced selling to meet them.


• The sentinels of the U.S. financial system haven’t changed. I have a hard time believing that the same career government officials, regulators and ratings agencies that were asleep at the switch when the financial crisis began suddenly and miraculously understand how to fix those problems - especially when most of those folks haven’t got a clue about how the financial markets actually work and most of them have never worked in them.


• Business conditions stink. There are very few companies that have not been materially affected in one way or another by this crisis. Profits are falling and dividends are being cut.Unemployment is rising, personal debt defaults are cascading through the system, and consumer confidence is in the cellar. Sustained recoveries require consumers who actually have money, have jobs and who feel confident.

Four Reasons the Bull Has Awakened From His Slumber

We’ve carefully studied the reason Tuesday’s updraft may be nothing more than a bear-market rally. Now let’s look at the other side.In the “this-might-stick” category:

• We’re finally experiencing some good news. Pandit’s Citi memo has provided the first real glimpse of hope in months - fancy accounting aside - and could ignite a rush into stocks as investors fear getting left behind. That could turn into a self-fulfilling prophecy, because…
  
• Investors have trillions of dollars in cash on the sidelines. According to some studies, there may be as much as $3 trillion to $5 trillion on the sidelines, held by investors who are just aching to get back into the market. It is widely assumed that this money will come roaring in and that it will somehow help the markets recover faster than they would otherwise. (Personally, I have to be honest and say here that I just don’t see it; the estimated $50 trillion that’s been wiped from the face of the planet during this crisis did not go into some magical holding tank. Those losses are permanent. But that’s another story for another time).

Technically speaking, the markets were primed for a rebound. And they remain so by many technical measures.