The Stock Market Horror Show

Let's just close our eyes (figuratively speaking of course) and ponder one of a myriad of potential outcomes for the stock market through the end of the year. We want to be clear that this is not a prediction, just a simple exercise that exists within the realm of possibility. Feel free to add your own if you are so inclined.

If we assume that stock market is really just a cruel mistress at heart, one would assume that the market is likely to work against the vast majority of people. At this point it seems safe to say that we have had a huge rally and a pullback would be necessary and expected. Unfortunately this view has been in place for weeks now as the rally approaches its three month anniversary. A pullback would be welcome, a pullback would be expected, which is why we have had NO real pullback yet.

It would make sense that most have missed the rally, paralyzed by fear and then run over by a stampede of never ending bulls. Those that have missed the rally are waiting for the long awaited pullback to get back into this market.

Fund managers are rumoured to be forced into the market at the end of the day in a fit of panic buying because they cannot get a pullback and they must keep up with their primary benchmark, the S&P 500. The volume has been lackluster for weeks now which would seem to imply that perhaps the mutual fund managers are not actually jumping in with both feet here, but the panic buying story does make an easy to read headline to explain a non-stop rally...

So we know that the rally has been relentless and many investors are waiting patiently for the first pullback, and there will be one, there is always a pullback... eventually. Let's just say that someday the market does experience a pullback of 5%. Perfect, those on the sidelines step on the field and get in this market for the next rally. But, what if that 5% pullback quickly becomes a 10% pullback? Do the new investors double down or jump ship?

If the pullback does start to accelerate a bit the perma bears could emerge from their underground bunkers to make bold predictions that we are going to new lows. The experts will tell you not to fear, it is very normal to "retest" the lows. Bottoming is a process they say.

Now after being burned by the 5% pullback, investors may decide to wait for a retest of the previous lows, 666 on the S&P on March 6th to be exact. With the S&P back at 900 everyone is convinced that if the market ever slides below 700 again they will throw all of their ammo at it.

It would be so easy to buy a successful retest near 666 on the S&P. Perhaps it doesn't get there, close, but the pros jump the gun leaving all of the average investors waiting at the train station with nowhere to go once again. A new rally begins, this one for the duration. Investors struggle to get back into the market, worried about unemployment, the economy and the doomsday depression scenarios from their favorite experts, authors, professors and pundits.

This scenario is of interest to us because those that buy without waiting for a pullback could get burned. If you buy the first 5% pullback you could get burned. If you wait for a retest of the bottom that never happens you get burned by missing the rally. This storyline is intriguing due to its ability to screw so many at one time while leading to higher returns that many will miss!

We cannot tell you if the more than 40% rally over the course of about three months is a bear market rally or a new bull market trend, cyclical, secular, whatever you like. Do your own work and trade accordingly. All we know for sure is there will be a story to tell and we cannot wait to read about it.

Godspeed.

Must Read on Why Home Prices May Continue to Decline

Robert Shiller, professor of economics and finance at Yale, wrote a piece for the New York Times (available here ) detailing why home prices may continue to decline in the months and years ahead.

Shiller was ahead of the curve in pronouncing the housing market a bubble ready to burst just like when he began to express concern over the stock market as tech went to epic levels. Many believe that housing is key to the economic turnaround. Jim Cramer for one believes we are on the verge of a bottom in housing right now. Perhaps Cramer and Shiller may need to compare notes.

It is going to be very difficult to mount a decent recovery without a major improvement in housing on the horizon. The next great concern is that the economy bottoms but the recovery is so slow, so weak that it still feels like a recession and we quickly slip back into recession. This scenario makes a lot more sense if Shiller is right on the housing market. This also might help explain why President Obama's team is looking to ramp up the stimulus as opposed to cutting back on some of the spending as encouraged by his opponents who believe we have already started to see economic improvement.

It is clear the economy has yet to bottom and start to improve, but the positive sign right now is that we have started to get less bad. There is much work to be done to turn this ship around and there will be even more work required to keep it moving in the right direction.