A Rally Here Should Be Viewed With Skepticism By Long-Term Investors

Thursday and Friday qualify as the craziest days I have ever seen in the market. With such remarkable volatility, I am focused on capital preservation, i.e., sitting primarily in cash. Since I am leaning bullish, I am holding some equity calls in commodity and energy-related stocks, including ATI, CENX, FCX, FSLR, NBL, POT, SII, and TS. Otherwise, I am hoping to see an IBD confirmation of the rally starting on Tuesday in order to put more money into the market. My watchlist is essentially the same as on Friday.

Looking at an overall thesis, Thursday’s rally indicated there is a good supply of buyers around the October lows. Looking at SPY (SPY), price is currently around 31% below the 200 day moving average. We had a failed breakdown on Thursday, followed by an very strong move higher on very heavy volume. With this second retest of the low, we set a higher closing low. While Friday’s selloff provides good reason for caution, we can be somewhat encouraged by the decreasing volume as compared to Thursday.

So, while I am not loading the boat, I want to be ready in case Thursday’s action portends a more sustained move off of the lows.

For long-term investors, a rally here should be viewed with some skepticism. Nouriel Roubini gives us a good fundamental overview, saying The Worst Is Not Behind Us:

For 2009, the consensus estimates for earnings are delusional: Current consensus estimates are that S&P 500 earnings per share (EPS) will be $90 in 2009, up 15% from 2008. Such estimates are outright silly. If EPS falls–as is most likely–to a level of $60, then with a price-to-earnings (P/E) ratio of 12, the S&P 500 index could fall to 720 (i.e. about 20% below current levels).

If the P/E falls to 10–as is possible in a severe recession–the S&P could be down to 600, or 35% below current levels.

And in a very severe recession, one cannot exclude that EPS could fall as low as $50 in 2009, dragging the S&P 500 index to as low as 500. So, even based on fundamentals and valuations, there are significant downside risks to U.S. equities (20% to 40%).

Roubini goes on to say that TARP will prove inadequate to recapitalize our financial institutions, therefore requiring a “TARP-2″. With the taxpayer increasingly on the hook to bail out giant corporations, it is worth considering how well the government has performed with our money so far. Gary Kaultbaum:

I rant because according to CreditSights, a research firm in New York and London, the U.S. government has put itself on the hook for some $5 trillion, so far, in an attempt to arrest a collapse of the financial system…$5 trillion. Where will they get this money from? Do they think Barbara Eden is going to appear in a puff of smoke out of her bottle to just conjure this money up?

I rant because no formal action has been taken to fill the independent oversight posts established by Congress when it approved the bailout to prevent corruption and government waste. Nor has the first monitoring report required by lawmakers been completed.

“It’s a mess,” said Eric M. Thorson, the Treasury department’s inspector general, who has been working to oversee the bailout program until the newly created position of special inspector general is filled. “I don’t think anyone understands right now how we’re going to do proper oversight of this thing.”

Yet, what has been done to stimulate demand within the economy? Jobs are being lost, and housing is still on its way down. Essentially nothing has been done to arrest the deterioration of the grassroots economy. As a result, bad debt will continue to accumulate on balance sheets, corporations like AIG (AIG) will see even more losses due to their credit default swaps, and the government will continue to redistribute money from taxpayers to multibillion dollar corporations. I sincerely hope we see a substantial change in policy under the new administration.

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