Death-Defying Rally May Not Mark Bottom

Like the nine Pennsylvania coal miners pulled from the depths of a flooded tunnel in which they were trapped since Wednesday, the stock market has seemingly defied the grim reaper.

Last Wednesday, as you may recall, the Dow Jones Industrial Average at first swooned to an intraday low of about 7533, only to bounce back to finish the day up some 490 points. The comeback continued Monday, with the Dow rising 5.4% to 8711.88, and now up nearly 1,200 points from last week's depths. The S&P 500 surged 5.4% Monday to 899.96, and the Nasdaq Composite jumped 5.8% to 1335.25.

With all due respect to the rescued miners and their families, the analogy between the miners' ordeal and the market is just too ripe. But there's a big difference. Those miners won't be going back down into that tunnel anytime soon. Despite buyers' eagerness to jump back into the fray Monday, investors and the stock market's future is less certain.

Indeed, if a true long-term bottom has been formed, investors should have ample time to get re-exposed to stocks and shouldn't feel compelled to rush headlong back into equities -- in other words, the opposite of what transpired Monday.

The optimists believe the market's lows last Wednesday will prove to be the bottom. They were encouraged that Monday's gains were led by financials, notably Dow components J.P. Morgan (JPM Quote), American Express (AXP Quote) and Citigroup (C Quote). The Philadelphia Stock Exchange/KBW Bank Index rose 6.8%, and the Amex Broker/Dealer Index jumped 6.6%.

Additionally, the purchase of Dynegy's (DYN Quote) Northern Natural Gas unit by Berkshire Hathaway's MidAmerican Energy Holdings subsidiary was a sign that legendary investor Warren Buffett sees value in the wake of the recent devastation.

The "bottom now" scenario is also supported by Monday's renewed strength in the dollar, bulls say. It's unclear whether stocks are leading the greenback or vice versa, but they have been running in tandem of late. The Dollar Index settled up 0.5 at 107.39 Monday vs. last week's intraday low of 101.10.

Trading volumes were down from last week's record-setting levels, with 1.77 billion shares traded on the New York Stock Exchange, less than any session last week. Still, volume was heavy (especially for a summer Monday), and the "confirmation" or "expansion day" theory states, essentially, a reversal is legitimized if you get a session of at least gains of 1% for major averages on greater-than-average volume three or four sessions after a reversal day.

Like many technicians, John Bollinger, president of Bollinger Capital and Equity Trader.com, has his own definition of a "reversal" day: a session of greater-than-average gains, range, and volume with advance/decline and up/down volume positive by wide margins plus a shift in dominance from new lows to new highs. Monday's session qualified on most counts -- advancers led by more than 4 to 1 in Big Board trading, on which up volume was more than 90% of the total. The exception was new highs/lows, with lows leading 84 to 27.

But "you can't have everything," Bollinger quipped. "Now, the base-building period starts."

Finally, many optimists noted the recent action in the CBOE Market Volatility Index, which had risen to as high as 56.74 intraday last week. Monday, the VIX fell 17.3% to 33.43. There is also anecdotal evidence, such as bearish covers on national news magazines and mutual-fund outflows, as signs a bottom must be in place.

Come on Down and Meet Your Maker

Cynics, however, contend there's little fundamental rationale for Monday's advance; no macroeconomic data were reported, and the big stock-specific story was Qwest Communications' (Q Quote) earnings restatement.

At the risk of repeating myself, I'll repeat what I wrote last Wednesday: "If the market were really going to toy with people's emotions (as it is wont to do), what will happen is Wednesday's rally will be built upon for a measurable degree of time and price, defying the naysayers. Then, just as folks start getting comfortable again, the bear will re-emerge more ferocious than ever."

That's my story and I'm sticking to it, for those who've inquired. Certainly, it looks like part one of the scenarios is unfolding. As for those wondering why I believe the bear will re-emerge with greater ferocity, consider the following, from Bernie Schaeffer of Schaeffer's Research in Cincinnati, who recently identified four major reasons why he hesitates to call this the bottom:

Market valuations are "in the stratosphere relative to what we normally see at major market bottoms, and this fact is being ignored by the vast majority." (Separately, Merrill Lynch strategist Richard Bernstein -- who like Schaeffer has been bearish for some time now -- suggested Monday the "variability/unpredictability" of earnings is most important and that "the equity market does not appear overwhelmingly undervalued" despite its recent decline.)

The dollar remains vulnerable to a "major additional decline," which could "crater the U.S. stock market even further while at the same time putting pressure on the Fed to hike rates," Schaffer observed. (Many skeptics believe the dollar/equities and gold are merely experiencing countertrend moves within larger trends that remain intact.)

A "crushing debt burden" on consumers and corporations in the wake of the stock market bubble and a potential housing market bubble. (As of March 31, total U.S. indebtedness was 287% of GDP, according to the Fed.)

Lack of capitulation by individuals, the popular conception to the contrary notwithstanding.

The Investment Company Institute Monday reported equity funds had outflows of $18.05 billion in June (with domestic funds losing $18.7 billion), the third-largest ever in dollar terms and the top two -- September and March 2001 coincided with important tradeable bottoms. However, that outflow represented only 0.54% of the previous month's assets in equity funds, ICI noted. More than $3.4 trillion remained in equity mutual funds at the end of June vs. under $2.4 trillion at the end of 1997 (which I use because major averages were back to 1997 levels last week.)

Outflows are "a small fraction of what they could be in a serious panic," Schaeffer suggested, noting opinion polls continue to show a high degree of faith in the market among retail investors. "This complacency does not preclude a major rally from here, just as a major rally off the September 2001 bottom was not precluded despite the widespread complacency that existed at that time," he continued. "But the 'all clear' signal for jumping back full bore into this market has not sounded, and the possibility of major additional damage before the ultimate bottom is far from remote."