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• The Stock Market of 2003/04: a Playbook for 2010? March 21, 2010

  It can be quite inspiring to compare current market conditions with similar situations in the past.  The US economy in 2010 seems to just about to exit a severe recession and the FED probably at the beginning of a tightening cycle.

  The prior tightening cycle started 2004 and by understanding market sentiment and events at that time, we can draft a possible playbook for the markets in 2010. For this post, I’m omitting many  factors, such as e.g. currency relations or individual sector performance. My intention is not to write an economic paper (which would be appropriate for the topic), but to point out a possible trigger that could end the 2009/10 rally.

  The Markets in 2003/04
  

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  The S&P 500 gained over 15% over a period of five months until the beginning of 2004 (I’m just  counting the final move after consolidation from July to September 2003). The rally from bottom to top even lasted 12 months (note that we just celebrated a 12 month rally in 2010). So what was driving the final 15% rally?

  Interest rates were low (FED rate at 1%) and bulls and bears were divided about the outlook for the US economy. The market was climbing the “wall of worry” (sounds familiar in 2010?): bears were afraid of a “jobless recovery” (again familiar) and excessive potential inflation (again familiar). Inflation fears had a slightly different emphasis: India and China were booming economies (again familiar) and driving up Oil and other commodity prices (there was less emphasis on excessive government debt as a potential source for inflation):

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  Note that Oil was “just” at $40 after a relatively mild recessions (when looking at job losses).

  My point is that markets were climbing in an environment of uncertainty with bulls and bears being in disagreement about the economic outlook (sounds familiar again).

  On April 2, 2004, the disagreement was resolved by a positive, very surprising  US job report showing that over 300.000 jobs were created in the prior month. Suddenly everybody
  was convinced that the recovery was for real. How did the markets react?

  They sold off! The job report marked the end of the rally. Why? It became clear that the FED would need to start tightening soon, which they in fact did three months later and
  thus trigger another leg down for US stocks.

  Playbook for 2010
  

  If 2004 is  a valid example for typical market behavior at the beginning of the cycle, we can draw the following conclusions for 2010:

  • the rally needs uncertainty in order to be sustainable. (even the Dot Com rally was based on uncertainty about future earings of Internet companies).
  • whenever we get confirmation that the economy is “out of the woods”, the current rally can end and we should take profits.
  • a correction will start well before the first move of the FED. The market is a discounting mechanism.
  • the immediate reaction to the first FED rate hike is usually negative and offers good short-term shorting opportunities.

  Granted, many factors are different now, but the good old advice “buy the rumor, sell the fact” should have been followed in 2004 and is probably a  good advice for 2010 as well.

  
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