In trying to explain the rally in the face of nothing but sensational negative news, I have tried to stress that all it takes is signs of stabilization in the economy and less negative sentiment to turn things around. A few weeks ago I was joking that if CNBC ran a headline that said “Guaranteed Bottom for Economy in 1H09” we would rally 1,000-2,000 points.
I believe more or less these things are what is driving the current rally but to focus more closely on the GDP debate, I think that Fed Governor Janet Yellen’s comments from yesterday were overlooked. After noting that she is “strikingly more optimistic” than her friends in the business world, she went on to explain the difference between “growth rates” and “level.” Wall Street is happy if growth rates stabilize regardless of level. Businesses and employees facing layoffs care more about level. But the best part of Yellen’s comments are the following:
“Second, it takes less than many people think for real GDP growth rates to turn positive. Just the elimination of drags on growth can do it. For example, residential construction has been declining for several years, subtracting about 1 percentage point from real GDP growth. Even if this spending were only to stabilize at today’s very low levels–not a robust performance at all–a 1 percentage point subtraction from growth would convert into a zero, boosting overall growth by 1 percentage point. A decline in the pace of inventory liquidation is another factor that could contribute to a pickup in growth. Inventory liquidation over the last few months has been unusually severe, especially in motor vehicles–a typical recession pattern. All it would take is a reduction in the pace of liquidation–not outright inventory building–to raise the GDP growth rate. In addition, pent-up demand for autos, durable goods, or even housing could emerge and boost demand for these items once their stocks have declined to low enough levels.”
This is a crucial point for the bull case. Just three weeks ago no one believed this despite the fact that it was true. And no one bothered to remember that the Stimulus bill was going to add hundreds of basis points to GDP starting in 2Q.
I think the best time to buy aggressively will be on the pullback from this first real rally since the September breakdown. The character of the market has changed for the better. The downside risk is more manageable now and the outlook is bit more balanced. I think we have upside into early April and then a pullback that should be bought.
I don’t mind not buying the low because the risks three weeks ago were greater than they are today now that some signs of stability have appeared in the economic and financial system outlook, investor sentiment has improved, and government programs are being given a chance to work.
In other words, even though the Dow has rallied 1,500 points the risk-reward trade off is better.