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Three Reasons Why This Rally Won’t Stick

If you’ve seen the market go up over the last few days, you might believe that the rally is back on.

Not so fast.

When it comes to financial assets, it’s important to gain some long-term perspective by looking at a chart. That way, you won’t get lost in the day-to-day moves.

And what does a chart of the S&P 500 look like? See for yourself:

See larger image

As you can see, the S&P 500 is trading at its September highs. This is not only the market’s highest point since the sell-off started in August, it also happens to fall just under the 50-day moving average.

Question is, will the S&P 500 keep moving higher? Not for a while.

Here’s the first reason why I think that: The latest upswing from late September happened a little too fast. I like to see rallies built on a longer base of support. The current rally has lasted just seven days.

A failure to get above that 50-day moving average could be all it takes to push the market down to its September lows.

Second, the U.S. economy is still showing signs of slowing down. Recently, the Institute for Supply Management (ISM) non-manufacturing index decreased from 59% to 56.6%. The ISM manufacturing index also dropped, from 51.1% to 50.2%. Note: Anything under 50% marks a contraction. This means manufacturing in this country is close to shrinking, which is not something one should expect to see in a robust recovery.

And the third reason why I expect the market to stay in a rut a little longer has everything to do with China.

I know, James Dale Davidson and I have been talking about China a lot lately. But it’s important you understand just how pivotal this massive economy is to our own fortunes.

If you don’t know what’s happening in China, then you’re going to lose money playing the markets. There are no ifs, ands or buts about it.

For some perspective, here is what I recently read from Bloomberg:

Beijing has yet to put together a credible response as to what should be done with zombie companies, the huge swath of unprofitable state-owned enterprises surviving on the good will of the Chinese government. Until it does, private companies in the world’s second-largest economy will continue to fight an uphill battle for growth, and China’s reform efforts will share a key characteristic with the mythical creature in question: not dead, but not really alive…

At the crux of China’s reform story — or the lack thereof — is what will be done with the nation’s state-owned enterprises, or SOEs.

These companies helped facilitate the nation’s economic reorganization. They enabled progress under the prevailing political order of the late 1970s, following the Cultural Revolution, with the gradual introduction of additional market forces.

China’s attachment to this inefficient system is arguably fostering deflationary forces via excess capacity, diverting credit from more productive uses, perpetuating the existing power structure in perverse manners, hampering much-needed competition and innovation and raising the specter of an unnecessarily painful debt-deleveraging process.

During a speech delivered in September, Chinese Premier Li Keqiang called for consolidation among state-owned enterprises by way of mergers and acquisitions, fortifying existing companies rather than clamping down on them.

What’s happening in China is a good example of why governments shouldn’t make major economic decisions. The Chinese government, through its SOEs, overbuilt capacity to an extreme degree.

The policymakers thought this would be a good thing. But the deflation spreading through the country — and the rest of the world — proves otherwise.

Will merging SOEs solve the situation? Well, did merging big banks in the U.S. really fix the financial crisis we recently went through?


All it did was turn 20 small problems into three massive ones.

China needs to allow the weak SOEs to fail, while selling the rest to the private market. Once businessmen are determining whether to expand production or save money (rather than the government), I anticipate we’ll see far better decision-making going on.

Considering how communist the country is, though, I doubt what needs to happen will actually take place. And that’s going to drag out this economic problem far longer than anyone can imagine.

As always, we’ll keep our eye on the situation and let you know if anything develops.

In the meantime, you can check out the open portfolio here.

No changes for this week, but if the trend changes one way or the other, expect some updates.

We’ll talk again soon.

Take care,

Charles Del Valle
Charles Del Valle
Editor, Strategic Investment