Over the past 24 hours, I've received numerous phone calls from investors inquiring about yesterday's big rally in the stock market. Many of those investors were perplexed by the rally, especially since the Federal Reserve cut its overnight lending rate by only 75 basis points instead of the 100 basis points that traders expected.
I too was initially a bit bewildered by the Dow Jones Industrial's 420-point surge. But I was much less surprised by the extent of the rally after reviewing several technical indicators.
Those indicators suggest that the following factors were in force in yesterday's stock market rally:
First, bargain hunting bullish investors were merely looking for a reason to add to their stock positions.
Also, speculative investors and short-term traders who had previously sold stocks short apparently decided to take some profits and buy back those stocks yesterday afternoon.
Finally, a large number of investors appear to already have exited the equities market, leaving only aggressive traders active in the market.
Short-term traders typically respond to the type of surprising news that was released yesterday by temporarily bidding up stock prices. However, those same traders normally hold their positions for only a few days, then often take the opposite side of a stock transaction once stocks have rebounded. They reverse course and sell stocks short.
Meanwhile, my experience suggests that many investors were probably somewhat relieved by yesterday's less-than-expected cut in the target Fed Funds rate.
Why? Because the 75 basis-point rate cut will likely cause the exchange-value of the U.S. dollar to decline by less than it might have fallen had the Fed cut by 100 basis points.
Thus far, the dollar has in fact responded favorably to yesterday's less-than-expected rate cut, as the dollar rose both yesterday and again today against the Euro.
So, where are stocks headed from here?
As I stated in an article I wrote earlier today, my models indicate that stock prices may have already bottomed. However, those models also indicate that the path of least resistance for stocks is still down and that stocks will trade in a volatile sideways pattern, at best, over the next couple of months.
In other words, despite the rally, there is no major catalyst to propel stock prices higher over the near-term.
Yet there are numerous ongoing negative economic developments that continue to bode poorly for the future direction of stock prices. For example, the housing market remains in a slump, the employment situation has continued to deteriorate, and growth in personal incomes has fallen sharply over the past few months.
In addition, household net worth fell during the fourth quarter of 2007 for the first time since 2002, and long-term interest rates have recently been rising in spite of the Fed's cuts in short-term rates.
Just yesterday, the U.S. Department of Commerce reported that construction of new homes fell during February to the lowest level in more than 16 years, and building permits for new housing starts — a very reliable leading economic indicator — declined 37 percent compared to the same month a year ago.
The manufacturing sector also shows more signs of weakening. The New York Federal Reserve Bank announced on Monday that its index of manufacturing activity fell during February to its lowest level since April 2003.
The non-residential construction market has seen a slowdown over the past three months, and a host of financial institutions have announced massive layoffs. As a result, the U.S. economy will likely continue to experience job losses over the coming months.
I therefore expect economic growth to continue at an anemic rate, at best, for the remainder of 2008.
For those investors who may be foolish enough to think that a severe economic slowdown won't hold down stock prices for at least a couple of more months, I pose the following question: What about the effect that persistent inflationary pressures could have on the equities market?
My research suggests that high oil and gasoline prices, as well as rising food costs, will continue to cut into the average consumer's pocketbook and cause consumers to significantly reduce their spending over the coming months. That's important: Consumer spending accounts for approximately 70 percent of the U.S.'s total output of goods and services, the gross domestic product.
So, rather than listen to the so-called Wall Street experts, I recommend that you do as my four-year-old daughter Christina does when she puts together puzzles.
Her puzzles seem complicated to me, but she is patient and gets them done.
I asked her how she is able to put together her puzzles so easily. "Daddy," she explained, "I use my brain to study the shapes of the pieces."
In stock market terms, my daughter grasps what seem to be complicated developments by analyzing all of the factors that affect the puzzle. Investors, too, should think through all of the factors and ongoing developments that affect stock prices — not just one rally or one new statistic — and consider how those factors are likely to affect their own investment portfolio.
The market is a puzzle, and you need all of the pieces in place to really see the picture.
In that spirit, I ask you to consider the following: The Federal Reserve so far has pumped $600 billion into the credit markets, lowered the target Fed Funds rate by 3 full percentage points, and essentially bailed out investment bank Bear Stearns.
Despite all this, stock prices merely rallied back to overhead price-resistance levels yesterday.
My experience indicates that today's failure to sustain yesterday's rally clearly indicates that the path of least resistance for stock prices continues to be down. I urge you once again to not get caught up in yesterday's hoopla.
My models do indicate that the bottom is in sight for equity prices, and that perhaps stocks have actually already bottomed. However, my more than 20 years of experience investing in the stock market has shown me that trying to pick a bottom (or a top, for that matter) is a futile endeavor.
I recommend for investors to continue to be patient and to sit on the sidelines in cash-like securities for now. I also advise investors to hold small positions in a basket of inverse-index mutual funds or ETFs to protect their capital against potential further declines in the equities market.
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