Kass: Wave Goodbye to the Rally

This blog post originally appeared on RealMoney Silver on April 21 at 8:15 a.m. EDT.

(Editors note: To get the other view of what's next for stocks, read Jim Cramer's column here.)

Encouraged by a nearly 5% ride to the upside last week, investors have been emboldened.

For the record, The Edge did not endorse a Cassandra-like market/economic prediction even when things looked dark during the height of the credit crisis in January and March.

Back in early February, I suggested that the SocGen market bottom would likely mark the averages' nadir and that the March test would prove to be another successful one. About a month ago, for emphasis, I became very bullish in my short-term market outlook, suggesting that a vigorous upside trading opportunity to the top end of the recent trading range could be forthcoming.

Those market expectations have been met. Year-to-date, the S&P 500 has declined by only 5.3%, at the bottom end of the 5% to 10% drop I suggested in my list of surprises for 2008. And now the S&P is nearly 10% above 2008's low. Many stocks (especially of a materials kind) have risen by even a greater amount.

Importantly, I would not confuse the current rally as evidence that business conditions are improving; they are not. From my perch, the pendulum of valuation has simply bounced off depressed, oversold and panicky levels toward fair to slightly overvalued levels. Indeed, equities continue to face a number of headwinds (the most significant being a consumer-led downturn), which suggest that optimistic profit expectations for the last half of 2008 and for 2009 might be unrealistic, posing a risk to continued stock market gains.

Economic Activity Is Slowing

While investors have been giddy with several high-profile profit beats last week (albeit from previously lowered expectations), a marked deceleration in organic growth at two of the larger diversified industrial companies -- General Electric GE, sequentially from 8% to 5%, and Danaher DHR, from 5% to 2% -- signal a more accurate reflection of emerging negative economic momentum. From my perch, a second-half recovery in the U.S. economy seems less likely than is widely assumed by market participants. If my thesis is correct, the strength in the emerging market economies (and the new paradigm of decoupling), which have served to stir the drink of non-U.S. profits, might be tested.

An Increasingly Giddy Market for Tech Stocks

The Nasdaq, after climbing vigorously in the second half of 2006, is now above January 2007 levels. (At Friday's close, I shorted the Powershares QQQ QQQQ.) Now trading at approximately 18 times forward earnings estimates, the technology sector incorporates the forecast of about 19% profit growth, which, based on current macro and micro trends seems unrealistic.

At the same time, the investment strategists at Merrill Lynch and Goldman Sachs warn that technology is among the most overweighted and least shorted sectors by mutual funds and hedge funds (reminiscent of six years ago). Moreover, amid continued economic uncertainty, business and tech expenditures will likely be reduced over the next six months. For example, despite the media's fanfare IBM's IBM hardware business was down 7% on a constant currency basis.

The two most important sources of end-market demand -- consumers and financial companies -- have only recently begun to cut back (within the context of the aforementioned and growing hockey stick expectations for recovery). It takes a while for large corporations to slam on the IT budget brakes (e.g., the summer 2002 downturn). Historical data on IT spending shows the cutting usually doesn't start until we are well into a recession and actually continues past the end of a recession and takes some time to recover. And there is no guarantee this will be a short recession either.

In light of the carnage in the financial sector, Citibank C stands as a template of how profit pressures will weigh on bank tech budgets and corporate tech budgets overall. Citibank has been under enormous pressure for a long time now and is just getting around to slashing its technology budget. The rest of corporate America is the same. It takes a while to put the brakes on a battleship, and this is the reason for the aforementioned pattern of technology budget cuts not occurring until well into a recession as budgets are adjusted.

Finally, European tech strength is a myth as it is almost only foreign exchange translation that is (optically) helping tech companies. On a unit basis, their European business has already turned down.