The Case for a Rally - updated

I have speculated about the possibility of an upcoming inflation-driven general stock market rally which would be synchronized with rising gold prices, creating a perfect environment for gold stocks (as represented by, for example, funds such as GDX), as well as stocks of other sectors sensitive to inflation, for example energy.

Such a rally would be relatively brief, but probably very powerful (more than a "dead-cat-bounce") given historical precedent from previous bear markets. It would provide an opportunity for intermediate term (6-12 month) traders to make substantial profits in the right sectors (I believe gold stocks to be one of them), some of which may reach true bubble valuations later in 2009 or in early 2010.

Those who believe that this is an utopian idea should study how the stock markets behaved during the Great Depression, which saw several rallies of at least 80%, including the greatest rally in U.S. stock market history, which took the Dow up 372% between the low in 1932 and the peak in 1937. Incidentally, this particular rally commenced just as FDR took office, and continued against a backdrop of draconian anti-market interventions.

The idea that such a rally is a strong possibility in 2009 is premised on the following observations:

1) Particularly after the Fed announced in December that it would embark on a policy of Quantitative Easing (a euphemism for running the printing press without restraint), several leading indicators of nominal economic recovery, inflation, and higher risk appetite begun to rally:

* The TIPS/Treasury ratio (TIP:TLT), rebounding from late December after predicting deep deflation. (The TIPS/Treasury ratio indicates the premium investors place on inflation protected government bonds vs. ordinary government bonds.)

* The Baltic Dry Index (BDI) begun to rally in early December. BDI measures shipping rates, and is a proxy for global economic activity (particularly involving emerging markets such as China), as well as for industrial commodity prices.

* Certain key commodities such as copper and oil (WTIC) as measured by continuos futures prices begun to rally in early December. The probability of the continuation of this positive trend for commodities is heightened by historically heavy insider buying in the energy sector from October and onward, as well as the recent outperformance of commodity related funds vs. the broader markets.


* The TED spread, an indicator of fear in the banking sector, has collapsed from a reading of around 4.5 in mid October to around 1.0 and staying there in the face of substantial banking problems resurfacing both in Europe and in the US. I believe that this indicates that the banks increasingly consider their peers safe counter parties by virtue of being either nationalized or put under strict fascist controls and spoon-feeding. This is an essential step in the process of the banking system being reconfigured to create credit by government decree, and it is an inflationary outcome. Once banks start to extend credit with some normalcy, the fractional reserve money multiplier is applied to the record amounts of money that the Fed has injected into the banking system.

* The ratio between corporate bond prices (junk: HYG, and investment grade: LQD) and Treasury prices (TLT) begun to rally in December, and even with the general stock markets having broken their November lows, investors, particularly in investment grade corporate bonds, have, as indicated by the resiliency of these ratios, not been convinced that it is now riskier to lend to corporations than to the government.


* The ratio between "risky" consumer discretionary stocks and "safe-haven" consumer staples related stocks (VCR/VDC) has not revisited its November lows despite the fact that the S&P has plunged much lower. This indicates that in the midst of the S&P breaking down, there is an undercurrent of re-allocation from safe-haven stocks to stocks more immediately benefitting from an economic recovery. The same phenomena is present in the Philadelphia Semiconductor Index steeply outperforming the S&P from December and on.


2) An uptick in monetary- and price inflation and their corollary, higher risk apetites, will lead to a rush into stocks during a window of suppressed intrest rates.

Record amounts of money now sits in the supposed safety of money market funds and checking accounts at zero or record low interest rates. As inflation expectations picks up (say, driven by rising commodity prices), money will have to flow into higher yielding instruments including corporate bonds, and stocks - the exact reverse of the now prevalent "flight to safety".

Higher long term interest rates - a result of inflation expectations among investors, and escalating government deficit spending - will ultimately put a lid on stocks. However, interest rates will rise from very depressed levels and the Fed's Quantitative Easing program will keep rates lower for longer, while creating even worse inflation and speculative flows into stocks and other risky assets.

3) The bearishness among the general public, the media, and economic pundits is so prevalent that one is justified to ask if there is anyone left in the market to sell stocks at this point. What piece of bad news has not been already priced in?

I shall add here that the biggest unknown affecting the likelyhood of the proposed rally scenario is the political factor.

This was seen quite clearly in February. For example, the rebound in the TIP/TLT ratio stalled on February 10 - the same day as Geithner gave his very badly received speech, and has not yet recovered to its pre-Geithner level. Against the backdrop of this and other political events in February, some of the other bullish indicators that I have mentioned have also suffered some setbacks. This development is something to be watched, and could provide clues to the effect that the bullish scenario might not materialize.

Here are some other bearish arguments .

Comments are very welcome!

PS. I have not mentioned the rally in gold and gold stocks as an inflation predictor, as I think that gold, and particularly gold stocks, may do well even in a deflation.