How Long Will This Rally Last?

The markets have been in a sustained rally since hitting the March lows.  Since that time, the S&P 500 has climbed more than 50% from the bottom.  While we’ve seen some noticeable improvement in the economy since than, there are still many ominous signs that make me weary.

Firstly, second quarter earnings were largely viewed as a success. The majority of S&P 500 companies managed to beat analyst’s earnings estimates.  This is a good thing.  However, the majority of these earnings beats were due to cutting costs rather than better than expected revenues.  All in all this isn’t necessarily a bad thing, provided that top-line revenues begin to increase in the upcoming months.  If revenues don’t begin to increase, than one had to question how long firms can continue cutting costs to drive earnings.

My second reason for being cautious right now is the high degree of bullishness on the housing market. Recent data has indicated home sales have increased significantly month over month and many have claimed that the housing market is beginning to bottom out.  This bullishness seems unwarranted to me because only the low priced homes are seeing an increase in sales/price (think foreclosures).  The mid to high end of the housing market is still stagnant and prices have nowhere to go but down.

Another reason to be bearish on housing is the first time homeowners credit.  Towards the peak of the housing bubble our country saw the greatest percentage of Americans in history own their own home. Put in a different perspective, we had the fewest percentage of potential first time buyers in history because everyone who wanted a home had already purchases one.  Yes there is a good portion of people right now who were/are looking to purchase a home.  However, most of these people are rushing to close on homes right now in order to take advantage of the government credit.

At first you may think this is a good thing.  But in reality all the first time buyers credit is doing is front-loading all the potential demand for housing that’s left (aka stealing from future demand).  I wouldn’t be surprised to see housing take another leg down starting in November/December after the credit has ended and demand from first time buyers wanes.  (Note: A similar argument can be made about the cash for clunkers program front-loading demand for new vehicles).

My final reason to question the extent of this rally is that it’s being fueled largely by hedge funds and institutional buyers who are being forced to buy stocks because they were under invested at the bottom.  When you’re running a hedge fund or mutual fund your investors are always comparing your returns to those of other hedge funds and mutual funds.  Therefore, if you were sitting in cash and missed the huge rally since March you’re going to desperately try and catch up to your peers who have benefited from the rally.

So despite some improvement in the economy since the lows, I still feel the need to advise caution.  I wouldn’t recommend selling all your stocks and hiding under your bed.  Just as I wouldn’t recommend jumping full steam onto this rally.  Make sure you have a proper asset allocation that matches your risk tolerance.  Also, take a look at your current asset allocation and make sure it’s inline with your target allocation.   The big rally of the past few months may have caused your portfolio to become over-allocated towards stocks.  If this is the case, rebalance your portfolio by selling some stocks and buying bonds or redirect new contributions into your fixed income investments.

Above all, remain vigilant and cautious about this or any other rally in the stock market. Remember, risk goes up as stock prices increase.  Don’t become complacent.