Securities Research Services

Sunday, November 16, 2008

The Potential for a Large Stock Market Rally

This week economist John Mauldin writes:

The Potential for a Large Stock Market Rally Everyone knows that there are large amounts of hedge fund redemptions being processed. Some blame the current vicious sell-off on forced hedge fund sales as they have to meet these redemptions at the end of the quarter. This brings up an interesting possibility. My guess is that the large bulk of that money is going back to institutions that will need to put the money to work. Where will they deploy it? If they are projecting 7-8% total portfolio returns, they cannot put that money in bonds. My guess is that it will go back to other hedge funds or into long-only managers. This money will start to go to work in mid- to late January. We could see a very large rally the first quarter of next year. For traders, this will be a chance to make some money. I think it will be a bear market rally, as the recession will still be in full swing, and we could see a pullback when that money gets fully deployed. But it will be fun while it lasts. As traders begin to sense that possibility, we could see a serious year-end rally as well. Would I bet the farm? No, but I offer up the idea as a possibility. And I know a lot of people have large short positions that have made them a lot of money this year. Maybe it is time to think about taking profits. And now a few thoughts on the possibility of bailing out GM.

So let's take a look at the market and see if there are any clues that back up this possibility.

In October we saw the market essentially fall off the edge of a cliff, which changed the volatility parameters and threw our Risk Assessment Meter (RAM) for a loop.

Just a quick summary, the RAM measured the distance of price from the mean (or 50-week average). When prices revert too far from the mean in either direction, then a counter trend rally or decline typically ensues as prices revert back to their mean.

The steep market decline changed the parameters of "normal" oversold conditions as volatility increased dramatically to historic all time highs.

Nevertheless, this does not discount the rule that prices still return to the mean, the increase in volatility just expanded the range. In other words, despite the massive sell off, prices will not go down forever. At some point a countertrend rally will develop as prices return to the newly expanded mean. Except now, since we don't have historical measures to rely on, we won't know how oversold is too oversold until we see prices turn around and rally. We do know, however, that prices will at some point turn around and rally and that that rally will very likely be a whopper.

Back to the SPY chart again:

The SPY declined by a massive amount in October, but over the past 6 weeks we have seen prices settle into a trading range. Last week prices threatened to break down through the floor of this range, but on Thursday buyers stepped in and pushed prices back into the range on a closing basis.

This is our first clue that we are potentially nearing the line in the sand that marks the point at which the markets are now too oversold to go any lower before we get the regression to the mean rally that is inevitable at some point.

We don't know yet if this is it, but the fact that prices have not been able to push through $85 on the SPY on a closing basis is interesting.

This does not mean it is time to buy. Rather, it means it is time to be careful and observant. If prices can break through $85 on a closing basis then we may be in for another decline before a countertrend rally develops. But we haven't seen that yet. Until we do, it's dangerous to open new short positions. At the same time, it's dangerous to open new long positions as well until we get a follow through day to the upside.

We made that mistake on Friday and we paid for it. We are now licking our wounds are will wait for either a follow through day or a breakdown before acting further.

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