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Why a Year-End Rally is More than Possible

0 | By Shah Gilani

Lately it seems everyone wants to know one thing: Are stocks going to rally through year-end?

The answer is an unqualified “maybe.”

To explain this uncertainty, let’s look at where the markets are today.

Last week, the Dow Industrials gained 1.4% to end the week at 11,808.79. The S&P 500 rose 1.1% to 1238.25. But the Nasdaq Composite fell 1% to 2637.46.

While it seems like stocks have come a long way in a short time – and they have – in the big picture, we’re still crawling and clawing our way up…

Today the S&P 500 is just 38.25 points above 1200. As a point of reference, the first time the S&P crossed 1200 was almost 13 years ago. The good news (maybe) is that it’s only 20% below its all-time high. And the Dow is just 17% below its all-time high.

However, after hitting 5048 in March 2000, the Nasdaq Composite is still almost 50% below that high-water mark.

It’s the Composite’s lack of traction that worries me.

It tells the story, not just of the tech wreck of 2000, but of technology and growth companies at the margins failing to get any meaningful traction. (And many are marginal indeed. Of the 3,000 companies in the Composite, most are smaller than the average companies in the S&P and Dow.)

Given that, you may find it hard to believe we can get back to old highs on the major industrial indexes.

But it is more than possible.

That’s because so many of the companies in these indexes are “global” in terms of their inputs, sales, and revenues. And thanks (almost exclusively) to global growth, these big companies are momentarily well positioned. Thanks to overseas sales, their earnings have been strong. And when the revenue streams earned globally are translated back into cheaper dollars, currency gains make net profit numbers a lot stronger.

In this sense, actually, the Fed’s quantitative easing programs helped hugely – both by lowering the U.S. dollar’s value and by lowering interest rates. Low rates allowed companies to re-tool their balance sheets by retiring debt and reducing the cost of outstanding obligations.

Regarding this most recent rally, the European picture is what brightened the big-cap world and set the stage for this upward movement. Specifically, it’s optimism that an effective backstop plan to save Europe from imploding continues to drive shorts to cover.

And if any plan put forward is even credible, it would set the stage for an even bigger market rally.

But we’re not there yet…

There has been no resolution, or even any meaningful indication that a lasting program can be put in place to withstand the systemic problems European sovereigns face.

And that is troubling.

Yet it doesn’t seem to be troubling the markets.

We’ve Climbed the European Wall of Worry

Last week, we broke through resistance on the industrial indexes. Volume wasn’t great, but it was better than it has been, given the upward moves.

That we’ve seemingly climbed the European “wall of worry” is something I simply can’t ignore.

In fact, it’s changed my short-term thinking.

I’m still skeptical that any plan to backstop Greece, pre-capitalize European banks, and provide adequate capital to facilitate growth across the European Union will really work.

But fighting the tape at this juncture could be a huge mistake.

If the path of least resistance is higher, I’m going to put aside my analysis and conclusions about Europe, for the time being, and approach putting on trades from the long side.

Miracles happen…

For a genuine rally, we’ll need three things:

  1. A credible European solution (at least for the short run). That would send our big indexes soaring, possibly approaching old highs within a few short quarters.
  2. Some quantitative easing would give us a helpful push. And in fact, Vice-Chairman Janet Yellen said only Friday that QE3 is definitely not off the table.
  3. China to continue to defy naysayers and post strong GDP growth and tamped-down inflationary pressures.

Then we’re looking good.

Of course, playing from the long side can quickly make you sick.

So I recommend using tight stops if you are putting on any new long positions, and then raising your stops if we continue to rally.

Just because I’m putting all my European analysis over to one side of my trading desk, doesn’t mean I’m not watching developments there. I am watching – intensely.

And the moment I see cracks in the cement containment apparatus they’re hoping to construct, you’re going to hear me yell, “SELL!”

For Now, the Numbers Inform the Markets

The major indexes will be working off a host of data points coming out this week.

Tuesday we get consumer confidence; if that number is better than recession numbers in the low to mid 40s, we’ll add that to the “plus” column.

Also important are Wednesday’s durable goods orders (expected consensus is -0.9%) and new home sales (expected consensus is 300k).

But probably the biggest economic news this week will come Thursday morning at 8:30 a.m. That’s when we get the preliminary third-quarter GDP number.

Some estimates are as high as 3.5%, and the consensus number is 2.5%. If we get anywhere between those two numbers I expect a strong positive reaction.

To finish up the week, on Friday we get personal income, September consumption, and October Michigan sentiment.

Bigger than these data points, however, is the fact that Europe’s governments are up against a self-imposed deadline of Wednesday to deliver their much-anticipated “plan.”

Like I said, I’m leaning in from the long side. But I’ll be putting on shorts positions at every meaningful push higher.

In other words, I’ll be averaging up into shorts, because at some point, there will be some profit-taking. And if data and European backsliding signal weakness, I’ll take whatever long profits I have at that juncture and add to all my shorts.

And we’ll go from there…

Shah

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