Bear Rally or the Beginning of the Recovery?

October 11, 2011

Investors have seen a number of favorable developments in U.S. & Europe over the past two weeks. In Europe, the fear of an implosion in European Monetary Union due to the sovereign debt problem in the peripheral countries, such as Greece, Portugal and Ireland, has subsided significantly. The main reasons were the measures taken to set the European Financial Stability Facility (EFSF) with a war chest of more than Euro300 billion to combat the sovereign debt crisis. In addition, individual countries are now moving to recapitalize their banks. Both of these measures would provide strong assurance to investors that the financial system would not collapse (especially in the core European countries such as Germany & France) and that this sovereign debt problem would be contained and would not migrate to other countries, such as Italy & Spain.

Over the Atlantic, the U.S. has also reported a number of favorable economic data, such as encouraging weekly jobless figures, which delivered a decline of 37,000 to a multi month low of 391,000; the improvement in retail sales (including automobiles); and ISM numbers that stayed above the critical 50 level. This is contrary to earlier negative reports concerning the state of the U.S. economy; the most prominent of which is the report from ECRI which indicates that the U.S. could be entering into another recession (here).

However, a few analysts & pundits have pointed out that U.S. inventory numbers are too high & ISM number after deducting the inventory number does not show a healthy picture. Amongst those who had spoken out about this sign of weakness is none other permabear, Albert Edwards of Societe Generale (here). All said, investors chose to pick on the positives & ignore the negatives and this led to a rally in equity & other risk assets.

Technically speaking, we note that all the major European & U.S. stock market indices have broken above the 50-day SMA line. With this breakout, these equity markets could continue to rise. Is this the beginning of a fresh upleg or is it just a bear rally? Only time will tell.

However, many of the Asian stock markets are still languishing not very far from their recent low. That’s rather disappointing since these markets have dropped nearly as much as the stock markets in OECD countries, where all the problems reside. Now that investors viewed these problems in Europe & U.S. in a better light, shouldn’t the same apply to the Asian economies & stock markets? I think that the tighter monetary policies implemented by many Asian countries to control inflation or to slowdown their overheating economy is to be blamed. These policies would slowly be rolled back as inflation fear subsides (due to decline in the prices of many commodities) & fresh concern about a slowdown in the economic growth (due to strong headwinds from the Europe & the U.S.). The relaxation of monetary policies could be the catalyst for a rally in Asian stock markets in the months to come.

Our FBMKLCI has tested its accelerated downtrend line at 1415 this morning. If it can break above this level, it could potentially test the medium-term downtrend line that stretches back to July 11. The resistance posed by this downtrend line is at 1445, which coincides with the strong horizontal line. On weakness, FBMKLCI can find support at the psychological 1400 level or at the short-term uptrend line at 1395. See the chart below.

Chart: FBMKLCI's weekly chart as at Oct 11, 2011 (Source: Quickcharts)

How should we play this rally? Like the question posted earlier, it depends on whether this is a bear rally or the beginning of a new upleg. To qualify as a new upleg, you need at least an upside breakout above the 1445 level (preferably the 1450 level). Failure to surpass this level would simply mean that the downtrend is still intact & the market may slide off again. As you know, that’s what we called a bear rally or a corrective move within a bear market.

To be sure, we must remain vigilant in this market. The problem in Europe is far from over. How can Greece and other countries in Europe compete in the global economy while being tied to a strong currency, the Euro. This is something that must exercise the mind of many economists in Brussels for many months to come. Without growth, I do not see how Greece & their cohorts can service their heavy borrowing and the failure to do so, would mean that Europe may once again be dragged to the precipice & stare into the abyss.

(This is my latest article in Merdeka Review. For the Chinese version, go here)