Has the Rally Run its Course?

oldpigwang

Has the Rally Run its Course?
Zacks Elite Market Analysis, By Sheraz Mian
2010年10月19日


A number of factors are behind the optimism that has produced a more than 10% run in the market over the last few weeks. The more prominent of these factors include decidedly positive (or less negative) economic news, solid earnings outlooks and the supportive Fed. One could add the expected results of the mid-term elections as another contributing factor. We had discussed all of these drivers last week: What's Driving the Rally?
While all of these factors are no doubt relevant, my focus today is primarily on the Fed; particularly the second round of the Fed's Quantitative Easing program. This program is generally referred to as QE2. QE1 was the Fed's original asset-purchase program prompted by the upheavals of late 2008.

My goal is to make sense of the market's response to expectations about QE2 and size up any further room for upside from current levels.

The emerging expectation in the market appears to be that the Fed will provide more visibility on the QE2 program following its November 2-3 meeting. We don't know about the size of the program at this stage, but my sense is that the central bank will start small, with a view to retaining the flexibility to ramp it up later should conditions warrant. But the market will like to know some measure of the cumulative size of the program at the outset.

The consensus view appears to be that the current ongoing rally will get a further boost from the actual announcement/implementation of QE2. I am skeptical of this notion. My sense is that the market has already priced in this Fed move and remains vulnerable following its strong run up thus far. With most of the positives already out there, the near-term move in the market will most likely be sideways or down, not up.

The Bull Case

The stock market's positive response to QE2 boils down to three main reasons. First, this program will significantly bring down, if not altogether eliminate, the odds of a double-dip recession in the U.S. It also helps the Fed address the deflationary fears that have been taking hold in the market. Secondly, by bringing the yields on longer-dated treasury bonds, the program will make stocks more attractive to investors in relative terms. Thirdly, the lower interest rates and enhanced liquidity will make the financial backdrop more conducive and supportive for the corporate sector.

The program's impact on the fears of a fresh economic downturn (double-dip recession) and/or deflation are beyond question. The resulting reduced economic uncertainty is a net positive for the stock market. The market also benefits from the program's focus on longer duration treasury bonds and the corresponding drop in their yields. Lower yields on all fixed income products, not just the treasuries, should help improve the relative attractiveness of equities over bonds.

The Bear Case

While I am not contesting the intellectual weight of the bull case, I find it hard to believe that those positives haven't fully played out already. Ever since it became clear that the Fed appeared serious about doing another round of quantitative easing, all the asset classes have been moving in the expected direction.

Yields on treasury bonds have dropped, credit spreads have narrowed, the U.S. dollar has weakened and commodity prices have moved up. The stock market itself has gained in excess of 10% at the same time.

All of these adjustments have taken place in anticipation of QE2. And most likely, these were the bulk, if not all, of the adjustments that could take place as a result of this policy. Granted, a number of details about the program have been unknown to the market. More clarity on the size and duration of the program could potentially work as a fresh catalyst for the market. But the 'surprise factor' could very well work in the opposite direction as well.

My Take

I think the QE2-inspired rally has run its course and may not have much upside from current levels.

Let's not forget that the reason the Fed is contemplating the extraordinary step of a second round of quantitative easing, in effect one of the last arrows in its quiver, is the economy's very weak state. Another round of weak economic reports, along the lines of what we saw last summer, could very well prompt the market to head down, offsetting the recent gains.

For a sustainable move up from here, we need a reversal in the nation's economic vital signs, particularly in the labor market. As long as monthly private sector payroll gains remain under 100K and weekly jobless claims over 450K, don't look for more gains in the stock market. The most likely move for the market over the coming weeks is sideways, with a very real risk of a down drift.

Portfolio Update

We made a total of four changes to the Focus List last week; adding and deleting two each. There were changes to the Timely Buys list as well, while the Growth & Income portfolio remained unchanged.

We added Herbalife Ltd. (HLF), the roughly $4 billion worldwide marketer of nutritional supplements and other personal care products. This Zacks #2 ('buy') Rank company joins the portfolio with a solid earnings momentum, decent valuation, and attractive dividend (yielding around 1.5%).

The addition of The Mosaic Company (MOS), the roughly $30 billion market producer of fertilizers, is a direct play on the red hot agriculture sector. Given the favorable macro backdrop, the outlook for this Zacks #2 Rank company remains very compelling.

We exited our Parexel International (PRXL) position after the downgrade of the stock to a Zacks #4 Rank ('sell'). Sticking with the investing discipline of the Zacks Methodology is a key component of how we run these two portfolios.

We got out of our World Acceptance (WRLD) position on account of growing concerns about expected regulatory scrutiny of the company's business model. We are concerned that the new consumer protection agency will frame rules detrimental to the operating prospects of this micro lender.


Best Regards,

Sheraz Mian
Director of Research