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Rally(ies) again

Date : 28/07/2009

Author:  Venkateshwaran Ramadoss

The current rally, baptized as “better–than–expected” rally; after the better than expected earnings season, is generating a good lot of optimism all around. All the bearish questions on the sustainability of the “green shoots” rally could pull the DJI down only by 7% from the highs of the previous rally and the downturn lasted merely for a month.  All asset and commodity prices are being forecasted upwards and analysts could come out with revisions in the full year earnings forecasts. If we extend the DJI chart to one year, it is clearly visible that new lows are higher than earlier lows, thus signifying the possibility of a long term bullish trend in the making.

However, this rally has gained only 12% so far from the lows compared to 21% gain during the same time gap of 17 days during the previous rally and average volumes are comparatively low as well and the TIM sentiment index, a traders sentiment barometer, points towards a neutral outlook (51.06). These are signaling imminent weakening possibilities, at least in the short term.

The bears cry foul on the relentless optimism shown by the markets when there is no structural change in the fundamental imbalances which caused the current malaise, and call this a bubble, as pronounced by the Dr.Doom, Nouriel Roubini himself (link), among many others. Skeptics cry of an allegedly  conspired market manipulation by high frequency trading systems (link) behind the current rally, at least partially, citing low volumes as an evidence. Some suspect the sustainability of the current earnings trend pointing out the one off gains and cost savings to be the reason and doubting sustainability amidst economic uncertainty. The 2001 recession was met with low interest rates by the fed and this time around, it is being complimented by quantitative easing as well. The fundamental arguments point finger at the liquidity created by these policies chasing risky assets as a reason behind the current rally(ies).

Why should the market rally when there is no absolute uncertainty in the macro picture??

Economic theory suggests that easy money policy should boost aggregate demand, (economic activity-GDP) by lowering cost of credit thus encouraging lending and thus increasing consumption (demand) and thereby closing the gap between potential and actual output. However, until he gets absolute certainty and confidence about his future income earning capacity, the consumer will not be ready to borrow and so will be the banks’ willingness to lend (link). Thus, the cheap money goes to reduce the cost of risk and multiplying the ability to take risk. A small positive or negative change in the willingness to take risk, triggered by a positive/negative development, is compounded by the ability factor and reduces/increases risk premium and causes rallies up and down.

Another reason is the current structure of the asset management industry and the typical asset manager’s compulsions. Possibilities are there that the shrewdest of them are penultimate fools and sit on a pile of cash with a need to get them invested as sitting on cash for long makes them temporarily redundant. This scenario makes them to bet on and against rallies thus causing the rallies in an effort to make some smart money out of it.

The role of the analysts community is to come out with different and convincing ideas to pull and push the market up and down depending on their beliefs and the side they take and they contribute their part as well. The incentive for the media is to provide its readers with updated views and as I wrote in my earlier post, the mood should constantly switch from positive to negative so as to remain interesting.

 How long will this continue??

If the argument that the impending economic growth will get us away from the current imbalances proves right, then this will continue until the consumer gets certainty about his future income earning capacity from a wealth effect or a contraction in the output gap. For wealth effect to happen, the liquidity should stop chasing the equity market full time and should move to another asset class, as it moved to housing in the previous recession. Would that be "cap and trade"?? We should wait and watch.

If the argument that unless the fundamental imbalances are addressed, sustained economic growth is not possible proves right, this will continue till such imbalance are corrected as a sustained economic recovery is not possible till then or until markets turn efficient so that there is no smart money making avenues on an average.

I hope the former is more likely than the latter.

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