IS THE RALLY DUE FOR A 50% RETRACEMENT? May 22, 2009

The rally began in early March when it became clear the huge bank bailout efforts were going to be successful in pulling the U.S. financial system back from the brink of total collapse.

Since the fear of that possibility had driven the market down to extremely oversold levels, the removal of that concern certainly justified the first half of the big rally off the March low.

The second half of the rally has been fueled by hope that the recession is going to end earlier than was previously thought. I think that half may have to be given back for now.

The hopes of an early recovery were sparked by surprise reports in March that retail sales, home sales, and durable goods orders had all reversed to the upside in February.

But the better economic reports in March were temporary. Reports since have shown retail sales, home sales, and durable goods orders back to the downside, retail sales for instance declining 10% in the first four months of the year.

Employment reports show workers are still losing their jobs at a horrific pace of more than 500,000 a month.

Meanwhile, the problems began in the housing industry, spread to the financial sector, and then into the rest of the economy, and I still believe the real recovery will have to begin in the housing industry.

However, just this week has come more evidence that the housing industry is far from bottoming, let alone recovering. Although Wall Street tried to portray it as a positive, the Housing Market Index, which measures the sentiment of home-builders, remains mired in deeply pessimistic territory (and who would know the prospects for their industry better). The builders’ sentiment index came in at 16 this month on a scale of 0 to 100, up just two meaningless points from 14 in April. That indicates that 84% of builders are pessimistic, only 16% optimistic.

That report on Monday was followed by the report on Tuesday that new home starts plunged another 12.8% in April, even worse than the 8.5% plunge in March.

It’s obviously not clear sailing for banks either. There’s a big difference between pulling a drunk back from the brink of falling off a cliff - and having him immediately become a useful citizen again. And so it has been with the banks.

The banks have been rescued from falling off a cliff. But the IMF says U.S. banks will need an additional $275 billion to survive a continuing recession. The U.S. government’s own stress tests determined the 19 largest banks will need an additional $75 billion, and told them they’d have to come up with some of that on their own. The banks have been doing that by selling additional stock to obliging investors, who have been willing to pay as much as 100% more than the shares were selling for two months ago.

The Fed also says it will not allow any of the 19 major banks to fail. And that’s all good.

But it’s still a long and bumpy road ahead for them before they will see a bottoming of the bad mortgages, credit-card, auto, and commercial loan losses that are still growing, let alone begin making new loans in quantities that will contribute to economic recovery.

Meanwhile, the nation’s medium-size and small banks are not classified as ‘too big to fail’, and 59 have failed so far in the recession. Friday brought the latest, BankUnited in Florida. The FDIC says that failure will cost its already weakened funds another $4.9 billion.

This week we learned that financial giant GMAC needs another $7.5 billion “to plug holes in its balance sheet” and will receive it from the Treasury Department.

On Friday it was rumored that General Motors will file for bankruptcy next week, receiving another $30 billion in government loans in the process. The previous week it was Chrysler.

And as a reminder that it is a severe global recession, several of the U.S.’s largest trading partners reported their 1st quarter economic conditions, and it was ugly. Mexico reported its economy (GDP) plunged a huge 21.5% (annualized) in the first quarter. Japan reported its GDP plunged 15.2% in the 1st quarter, its biggest quarterly decline in 54 years. And Germany reported its GDP plunged 14.4%, it worst decline in 40 years.

The minutes of the Fed’s last FOMC meeting were also released this week, and revealed that Fed Governors are thinking about raising the amount of Treasury and mortgage-related securities they will have to purchase, beyond the $1.75 trillion already committed. They also projected an even deeper recession than they were expecting just three months ago, and a more sluggish recovery after the economy eventually bottoms.

Putting it all together, I believe investors’ optimism that the economy is already in a bottoming process has gotten ahead of itself.

If so, the stock market rally that saw the S&P 500 gain a huge 37% in just eight weeks, to its high two weeks ago on May 8, has probably also gotten ahead of itself.

It’s also not a good sign how quickly risk-taking has become sexy again. Nor that in their big rallies, the major market indexes reached the resistance at their 200-day moving averages two weeks ago, and so far have turned down from that resistance.

I correctly predicted in early March that an explosive and substantial bear market rally would be launched from the very oversold condition of the major indexes beneath their 200-day moving averages.

I now believe odds are very high that the rally will roll over into a correction that will retrace half of the rally’s rise. That would take the market down to a retest of last November’s low, but probably not all the way down to a retest of the March low.

We shall see.

Sy Harding publishes the financial website http://www.streetsmartreport.com/ and a free daily Internet blog at http:/www.SyHardingblog.com. In 1999 he authored Riding the Bear – How To Prosper In the Coming Bear Market. His new book is Beat the Market the Easy Way! – Proven Seasonal Strategies Double Market’s Performance!