The People's Rally

That the market has remained near its highs more than a month after the rally began — even in the face of waves of self-flagellating Muslim Shiites demanding an end to the US occupation of Iraq and similarly (if only figuratively) masochistic European nations vying for their share of a pie they hadn't wanted to see divided in the first place — is perhaps correctly seen by the procapitalist, prowar folks as further vindication of their infallibility. (What else but a serious case of triumphalism would have occasioned the decision of foreign policy neophyte Newt Gingrich to take on the entire diplomatic establishment of the United States?)

Even market fundamentalists, weary of the bone-cracking contortions necessitated by explaining over the past few months how the stock market needed to catch up with the economy (or how the economy needed to catch up with the stock market or how stocks were "cheap" in any and all events anyway so just load up on equities now and I'll see you at the shopping mall), found much to love in the March 13th rally.

Earnings season has been as buoyant as an e.e. cummings poem of spring, with companies in some instances reporting profits that would elicit cheers in virtually any market environment. Even where guidance for the balance of the year was negative, guarded, or nonexistent, the market seemed incapable of having too much of a good thing — even if that good thing had a "born on" date of March and a "best by" date of May. Finance, as has repeatedly been the case since the capacity to monetize became synonymous with the capacity for economic growth, was one of the leading sectors in the rally that began in mid-March, as noted by the American Stock Exchange's financial exchange-traded fund, XLF, which was up 17% from March 13 to April 23 against an Standard & Poor's 500 that was up 14% over the same period.

It's been many moons since technology stocks were leading much more than the surest route to equity impoverishment. But all that changed in mid-March. The QQQ — representing what had been the "best and the brightest" of the technology world — was up a modest 12%. But the Philadelphia Semiconductor Index was up an eye-popping 21% from March 13 to April 23. Nor did those who abandoned tech stocks in preference for the more staid world of the average common stock have much to complain about in the March 13th rally. The Value Line indexes (common measurements of the "average stock") were up some 15­16%, reflecting further the great magnanimity of the market since mid-March.

But perhaps the most surprising development was that the spring rally provided grist for the dusty mills of Dow theory technicians and other market dinosaurs who still believe that transportation stocks lead the market — whether those transportation stocks represent railroads or jet planes.

While the business news was filled with stories of indignant stewards and stewardesses, rapacious airline industry CEOs, and pilots whose capacity for both drink and various states of on-the-job undress was revealed to be alarmingly high, the AMEX transports ishare quietly mustered together a 19% rally from mid-March to the penultimate week of April, with the Dow Transportation Index itself notching a 21% performance.

Figure 1: Up, up, and away. The Dow transports average was the unheralded star of the March 13th rally.

To paraphrase Yeats — or, more accurately to my memory, to paraphrase Joni Mitchell singing the Irish bard's most famous verses — surely some revelation is at hand. After three years of bear market, is the second coming of that bull market magic slouching toward Wall Street to be born?

THE ARGUMENT FOR THE ARGUMENT AGAINST

If there's one problem with the People's Rally (and, as you might imagine, more than one problem exists), that problem might be that the rally has been oddly devoid of, well, people. I don't mean this rally has not arrived on the wings of significant volume; on-balance volume has been strong and rising, and money flow indicators have been only somewhat less so. What I mean by the relative lack of "people" is that the early adopters of the March 13th rally were overwhelmingly institutional in size and scope. As Aaron Task, senior writer at TheStreet.com, noted in an April 25th column:

"Surface indications suggest the investing public is relinquishing the hard-earned skepticism of the past 15 months or so, and starting to match the ongoing bullishness of Wall Street. That has potentially widespread implications, as money from individuals could provide another boost to the market. "

There is much to support the thesis of growing bullishness, beyond the obvious fact of rising stock prices. The VIX, a sentiment indicator that is often ignored when ignorance is convenient (impending market tops), has moved into a complacency range territory the likes of which have not been seen since spring 2002, when the S&P 500 was above 1100. And media commentators, who were never really much chastened by the three-years-and-running bear market, have been encouraging average investors left and right to swarm around the rising equities market.

In addition, even if the current rally is of the bear market variety, previous bear market rallies since 2000 have seen the S&P 500 rally by approximately 22% — which suggests that even if the S&P party is a little more than half over, there should still be plenty of time to cut a rug and quaff another cocktail before it's time to go home.

But as Task points out later — and as market historians never hesitate to remind us — by the time retail investors climb aboard the bull market train, the locomotive is usually nearing its destination. When the average investor begins buying in earnest, particularly in a secular bear market environment, it is often time to sell.

One of the places where this is most glaringly observed is in comparison of S&P 500 futures contract ownership. As illustrated in Robert Prechter's Conquer The Crash, professional traders and the trading public have diverged significantly at major market turns. In the mid-1990s, for example, when large traders and commercials were heavily long the market, small traders were largely short. In contrast, in 2000 and 2001, as large traders — generally regarded as the "smart money" — were achieving record large short positions, small traders were almost equally passionate about their long positions.

This information, currently available at the Commodity Futures Trading Commission's website at www.cftc.gov under "Commitment of Traders (COT)," points to a similar divergence in spring 2003 — in direction, if not in scope. The COT report as of April 22, 2003, shows large traders, commercials, and small traders (nonreportable positions) all to be more or less equally split between long and short positions with regard to the full-sized S&P 500 futures contract. The picture for the e-mini S&P 500 — far more the domain of the small trader than the full-sized contract — is quite different. Here, commercial and large traders are almost 2 to 1 short, while small traders are 10 to 1 long — and their numbers are increasing.

Interestingly, this relationship between full-sized and mini stock index futures contracts holds for the S&P 400 and the Nasdaq as well. At the risk of oversimplifying (there is surely some hedging among the commercials and large traders), although the large traders have not made a clearly observable directional commitment to the market, the small traders who are most often wrong have made a fairly resolute commitment — higher stock prices or bust.

BUOYANT BONDS

One of the factors that has most fascinated me about the March 2003 rally in stocks has been the resilience of the government bond market, the prices of which have been "melting up" (to borrow a phrase from Doug Noland of Prudent Bear) every time the stock market has melted down. An intermarket pattern that has been increasingly apparent over the past three years is the inverse correlation between stock prices and Treasury bond prices (see my discussion of Gibson's Paradox in Working Money).

This inverse relationship has proved somewhat complex during stock market corrections: for example, prices on the 10-year Treasury note moved positively with the S&P 500 as the stock market topped in from autumn 2001 to spring 2002. But the bull market in bond prices began again, just as stocks in 2002 entered their long slow slide from the highs of spring 2002 to the lows of that autumn.

The conventional explanation for the inverse relationship between bonds and stocks is that, in recent times, stock purchases have represented an "appetite for risk" while bond purchases have represented a "flight to safety." As more and more investors move toward the safety of bonds, particularly long-term Treasury bonds such as the 10-year, that safety becomes relatively less safe — bond yields moving inversely to bond prices. This is especially relevant as yields on 10-year Treasuries plunge beneath 3.9%. At this level, with the March inflation rate reported to be 3.02%, 10-year Treasury yields are barely skipping over the inflation rate like a flat stone across the surface of a still lake.

With an after-inflation return of 0.9% on a 10-year Treasury, the fact that they remain relatively attractive compared to equities — as judged by their price action in 2003 — should be as worrisome to stock investors as it is to bond investors. If the revelation is at hand, that "exquisite moment" (as at least one stock market commentator has called March 13) during which the bear market in stocks turns — however briefly — into a bull, then why does what can only be called the "deflation premium" in long government bonds prices remain? If the time for stocks is right here, right now, why are so many investors willing to accept a 10-year bond coupon that barely surpasses the rate of record-low inflation?

Perhaps some pouting and doubting may be in order after all.

David Penn may be reached at DPenn@Traders.com.

SUGGESTED READING

Penn, David [2002]. "Gibson's Paradox," Working Money: March.

Prechter, Robert R. [2002]. Conquer the Crash, John Wiley & Sons.

Task, Aaron L. [2003]. "Main Street takes a turn for the bullish," TheStreet.com: April 25.

Chart courtesy of TradeStation

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.