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Rally Runs Its Course

This column originally appeared on Real Money Pro at 8:27 a.m. EDT on June 11.

NEW YORK ( Real Money) -- On the morning of June 1, with the futures already down by 26 handles in the early going, I delivered the contrarian and variant view that we should be on the lookout for a rip-your-face-apart rally, citing Sir John Templeton, "The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell" (and technical analyst Walt Deemer the day before that, "When the time comes to buy, you won't want to").

A rip-your-face-apart rally could be, I surmised, the maximum pain trade given the broad de-risking by most investing classes.

With investor sentiment (individual and institutional) so downbeat, Wall Street strategists silenced and crestfallen (according to Mother Merrill, sell-side strategists are more bearish on equities than they were at any point during the collapse of the tech bubble or the recent financial crisis), expectations for worldwide economic growth and profits subdued, undemanding valuations, a five-decade high in risk premiums and a growing consensus view of "no way out" of Europe, the dour investment backdrop seemed to have the potential for a meaningful surprise to the upside for the U.S. stock market.

Ten days ago, I went through a number of conditions that could (either single-handedly or in a combination) contribute to a rip-your-face-apart rally.

  • Europe: A more activist ECB surprisingly intervenes (before markets force them) in order to stabilize the growing debt crisis. The ECB lowers interest rates, reintroduces SMP to support the purchase of weak sovereign debt, endorses a bank-chartered ESM and introduces a FDIC-like deposit insurance program for European banks. The concept of eurobonds floated by a heretofore reluctant 17-country constituency could also be a rally catalyst.
  • Greece: Two weeks from now, the Greek election will bring forth a pro-troika coalition. The election is followed by a less demanding austerity edict by European authorities.
  • QE3: The Fed hints of more easing in the days leading up to the June Fed meeting. Job growth is anemic in the U.S., stock markets around the world are plummeting, commodities are weakening, and the situation in Europe is unsettling (raising the risks of a deflationary shock) -- all of which are conditions for an imminent move by the Fed. (Indeed, the odds now strongly favor a near-term and synchronized monetary easing in China, Europe and in the U.S.)
  • U.S.: Economic data show renewed strength following May's uneven results. (For example, in times like this, we ignore some of the positives such as the lower price of gasoline, which could fuel retail sales in the period ahead, improve consumer sentiment and buoy corporate profit margins.) Another catalyst to the upside could be if the Republican Party gains momentum in the polls. (On Intrade, the likelihood that Obama wins the Presidency is down to about 56% from 62% a month ago. Today's jobs report is likely to result in an increased likelihood of a Romney victory in November.)
  • Mergers and acquisitions: One or two large, high-profile takeovers emboldens investors. (Corporations sell at large discounts to private market value. As evidence, to date in 2012, there have been 40 deals at over $300 million in market cap. The average takeover premium was 35%.)
  • Individual investors: Retail investors cease redemption of domestic equity funds and begin to reallocate funds into stocks and out of bonds.
  • Out of the blue: One day, with no news or provocation, the market ignites to the upside because all of the negatives are known and discounted.

Understandably, some of the most ardent bulls grew sheepish a week ago after the June 1 session saw the S&P 500 fall by almost 3%.

Several observers were down right ghoulish -- for instance, Professor Steve Keen (hat tip Zero Hedge) suggested a Chicken Little economic scenario, featuring a Depression-like deflationary spiral that could lead to plunging asset prices that would end the economic world as we know it.

My call for a rip-your-face-apart rally was quickly met with skepticism from numerous quarters (on Real Money Pro, on Twitter, on message boards, etc.), but even as the S&P 500 threatened its 200-day moving average and even with individual stocks breaking down on June 1, the rally occurred almost immediately.

As the European news deteriorated last week, the market did what it does time and time again; it rallied in anticipation of another policy move intended to keep the sovereign debt crisis from expanding.

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Chart of I:DJI
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