After Huge Rally, Market Digests Earnings Season and Bank Capital Raises

With most first quarter earnings reports having already been released, along with bank stress test results, the action in the market has died down considerably. After a 40% rally, the S&P 500 has been consolidating between 875 (a key technical support level) and 930 (the recent high). Such backing and filling is a strong sign. One would expect a pause after such a huge move, and despite the fact that the banks are rushing to issue billion of dollars in new shares, the market is absorbing that new supply fairly well (the stocks are down from their highs but they seem to be building a base and fear has subsided).

As for earnings season, first quarter results largely exceeded reduced expectations. Bulls and bears will continue to debate whether beating those low estimates was a positive or not, but merely stopping the earnings decline would serve to put a floor on stock prices. If the rate of decline in both the economy and corporate profits can decelerate, we could very well see sideways market action for a while. With the S&P 500 up from 666 to nearly 900, that would be welcomed by most investors.

The recent rally has been predicated on the idea that Q4 2008 and Q1 2009 will turn out to be the worst quarters for the economy. If GDP can rise sequentially throughout the year, and turn positive on a year-over-year basis by the fourth quarter, corporate profits will likely have hit a bottom. This scenario is priced into equities, so we really need it to play out that way for the S&P to hold the 900 area in coming months.

There are still plenty of people who are negative on the economy and either don't think a rebound will occur later in 2009, or if it does, it will be short-lived and we will see even worse times in 2010. If that proves true, we could very well see a retest of the March lows, as the bears are expecting.

Where do I come down? I think there is a decent chance we do not see 666 on the S&P 500 again. By "decent" I mean, say, between 50% and 67%. The rest of 2009 could very well be rocky though, so we could certainly get a correction or two, especially after a 40% rally in the market. As a result, I am holding some cash (10-20% right now in many cases) in order to take advantage of any other leg down if we get it. That cash number will likely increase if the market rally continues and we approach my own fair value estimate (1000-1050 on the S&P).

In general, I think a solid path would be for the market to trade sideways for a while. Digesting the big move we have made, rather than simply seeing another large sell-off (which was the typical course over the last year or so) would send a signal that the worst may be behind us and we can slowly recover. I agree with many who believe an economic recovery will be neither particularly fast, nor violently strong, but simply muddling along with little or no GDP growth would go a long way to supporting stock prices at their current level and take the calls for 600 on the S&P off of the table.