Stocks Can't Reach Higher Levels Unless Foundation is Built.

Here's an article I found in Forbes today by “Dr. Doom” himself - Nouriel Roubini. In the article, Mr. Roubini raises several excellent points, including his bear-market rally conclusion. It could be argued, as Mr. Roubini and others have, that stocks -- which have been on the upswing since early March -- are doing little more than producing a counter rally to the firmly entrenched bear. This argument has merit, provided stocks fail to complete their 3-part process of building a bottom from which higher levels can be achieved.

Headline indicators making new lows weren't being confirmed by more than a few other important indices, and what set the stage for the catalyst was the fact that the markets were primed for any good news - with the catalyst being the positive Citigroup news that their business over the first 2 months was doing just fine. With the setup in place, the stocks reacted to the catalyst quite well with the requisite power move when both the advance/decline on the NYSE and its advance/decline volume met or exceeded a 10 to 1 ratio. To help seal the deal, stocks then met yet another bottoming process requirement, in which “sustainability,” which must be met with “(1) no big retrenchment” and “(2) another big up-day.”

So far, so good. But is that a market bottom? Or is Roubini right when he says “…we've had 6 bear-market rallies, and at the beginning of each one of these suckers' rallies the delusional perma-bulls repeated that this was the beginning of a bull-market rally. And for 6 times these perma-bulls were totally wrong as the rally fizzled and new lows were reached. And for 6 times I correctly pointed out that these were bear market rallies”?

At this moment, the answer lies in whether stocks take that final step and produce what's needed to complete the market bottoming process: the upside breakout.

For a market bottom to have been built, the final part must fall into place: the upside breakout from the trading range that's been established over the past several weeks. Frankly, the odds are against that occurring right now, and that it will likely take more time and work before it does occur. This can be seen from a valuation perspective.

Two days ago, “investors stared into the abyss of the Great Depression II, and came to the conclusion that a couple trillion dollars thrown at the world economy -- along with an era of better regulatory management and a most appropriate change/modification to mark-to-market -- will generate 2008 operating earnings for the S&P 500 at something north of $50."

Moreover, “…the perception that the end of world may not occur this year has led many investors to conclude that an appropriate P/E between 12.5 (bad times) and 15 (average times) applied to a $60 operating earnings number is where equities belong. And that gets to almost exactly where the market is today: P/E of 13.75 (average of 12.5 and 15) times $60 = 825.”

That’s the good news.

Investment Strategy Implications :

The bottoming process is well underway. However, only when it's been completed by producing an upside breakout above its previous rally high can the rally be perceived as something more than yet another false dawn.