Wednesday, June 22, 2011

Don't get too excited about this relief rally

I have been expecting a relief rally for some time now (see Poised for a "transitory" rally). After the market strength yesterday and the news after the close that the Greek government had survived a non-confidence vote, stocks appear to be poised for a rally.

Indeed, my favorite overbought/oversold indicator, which had dipped into oversold territory, has now flashed a "buy" signal by rising above the 0.50 oversold line. Such conditions have historically resulted in a market rally that has lasted 1-3 weeks.

Don't get too bullish
Despite the short-term bullish bias to the market, I wouldn't get too excited about the upside potential of this market. I wrote on Monday that "I would be using market strength as a opportunity to lighten positions" and I stand by that comment.

First of all, it is rather disturbing that there was no relief rally in the Financials. Despite the market strength on Tuesday, the Banks underperformed on a relative basis. Note that I had warned that relative market weakness in the banking sector is a signal of growing systemic risk in the financial system that that assessment remains unchanged.

Second, Mark Hulbert reports that while bullish sentiment has retreated along with the market, consensus market sentiment is not bearish enough to signal a bottom:
The bottom line? While bullish sentiment has fallen since late April, its decline is less than the average drop at the beginning of past bear markets. And this was the case for all four of the sentiment indexes studied.

What could go right for the bulls
To be sure, there is a gleam of hope for the bulls. Fed Chairman Ben Bernanke could surprise the markets by hinting at QE3 on Wednesday - which would spark another "risk on" trade of enormous proportions.

In addition, Chinese premier Wen Jaibao will be in Europe this weekend. Given that there have been reports that the Chinese have been diversifying away from USD assets and into euros, it would be in their interest to seen the euro remain a stable currency and minimize the risk of a breakup of the euro. As a result, China has a vested interest in the health of the euro and if a crisis were to occur, the PBoC could conceivably ride to the rescue.

All this, of course, is just speculation about policy direction of different players on the world stage. The weight of the evidence, for the time being, remains with the bears.

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