US equities to have a sharp rally

Last week the financial markets had reached extremes. The US stock market as measured by the S&P 500 and the Nasdaq had become deeply oversold with respective declines of 13% and 25%.

From the top in March 2000, the S&P 500 is now down by 36% and the Nasdaq by 71%. At the same time, the US dollar looks oversold against the Euro and the Swiss Franc while US Treasury bonds and gold are overbought.

In fact, the Nasdaq was almost as oversold as following the September 2001 stock market collapse and several technical indicators we follow are giving signal that a more meaningful advance might just have started, which could lift the Nasdaq by 20% to 30% and the S&P 500 by about 15%. The 10-day put/call ratio hit .972 in late June, which is the highest reading since this ratio touched 1.01 at the September 21 low.

Moreover, the percentage of bears as measured by the American Association of Individual Investors rose to 46% on June 26, which was even higher than its last high on September 20, 2001. Finally, the S&P Commitment of Traders data shows that the commercials have largely covered their short positions, while the short position of large speculators is at the highest level in seven years.

So, here is how I see this oversold position leading to a relatively sharp advance. The stock market in the US follows a seasonal pattern. The market shows a tendency to bottom out in November and then to rally into January. In February, it is common for the winter advance to experience a correction, which is then followed by a spring rally lasting towards the end of April. May/June weakness then follows, and major lows occur frequently during this period.

In July, a summer rally lifts stocks into August. September/October tend to be weak with many major crashes such as in 1929 and in 1987 taking place during these two months. Therefore, based on this seasonal pattern of strength and weakness, which implies strength in July, combined with the oversold position we are now in, I am near term actually quite positive for US equities.

In particular, investors might want to focus in order to take advantage of such a rally on stocks, which have a large short position outstanding such as telecommunication, media and high tech companies. Moreover, as the most oversold sectors of the market rally, it is very likely that the correction, which began about one month ago in gold and gold shares, will continue for some time. This especially since the US dollar is also moderately oversold and could bounce back to around the 90 level against the Euro.

In sum, both the US stock market and the dollar could rise in the near future and enable traders to make some decent money. But as mentioned above, while stocks are oversold, US treasury bonds are fairly overbought and are now likely to weaken or could even enter a longer-term bear market.

My concern regarding bonds centers on rising inflation rates around the world with or without an economic recovery, due to excessive liquidity injection by the central banks.

Commodity prices have been firm since the beginning of the year and after having been in a bear market for more than 20 years they are poised for a very powerful advance in the next few years. Also, while the stock market and the corporate bond market were weak in the first half of 2002, investors shifted their funds into Treasury bonds - an asset class, which was perceived to be without any risk.

Therefore, if the stock market recovers now in July, it is most likely that investors will sell Treasury bonds and reallocate their money from this safe but also boring asset class to more risky but more rewarding equities and possibly corporate bonds.

So far my point has been that financial markets may have reversed their trend most recently. Stocks from down to up, the dollar, which has declined for straight five months from down to up, while Treasury bonds, which were firm up to now, from up to down. The more fundamental question is of course to what extend this reversal, which I expect to last for a few weeks and to be sharp, does signal a real change in the trend. Here, I less optimistic.

The US dollar weakness in recent months is likely to have been the first phase of a more prolonged bear market, which will lead towards a significant depreciation of the US dollar against a basket of commodities. Moreover, while the S&P 500 and the Nasdaq are near term very oversold, the valuation of US equities is still high and there remains the possibility of another recession brought about by a slump in consumption once interest rates rise.

Also, while the market is near term oversold, sentiment towards stocks from a longer-term perspective remains too optimistic. Cash positions are, today, nowhere near where they were at major market lows such as in 1974, 1982 and 1990, and insider selling remains at an uncomfortably high level.

Finally, the de-leveraging of the US corporate sector has just begun. In the late 1990s, companies repurchased shares and issued bonds to finance these share repurchases. In future, however, I envision an environment where on each market rally companies will issue shares in order to improve their leveraged balance sheets.

Thus, the supply of equities will remain high at a time when the demand will likely be more moderate, as households still hold 57.1% of their assets in equities, which is just 0.6% below the old time high of 57.8% in November 2000.

I am, therefore, still of the view that a sharp market rally aside in the near future, the very best we might expect from US equities is a trading range for the S&P 500 from about 950 to 1200. Moreover, if the dollar and bonds should experience a more pronounced bear market in the next twelve - as we expect - then stocks will be pressured by reduced foreign buying ands rising interest rates. But, as explained for now, a trading rally has a high probability with the Hong Kong stock market, which has a close correlation to US equities also participating.