"In the business world, the rearview mirror is always clearer than the windshield"

     --Warren Buffett

• From a deeply oversold condition, our work suggested the probabilities favored a near-term rally for equities. At its recent low, the S&P 500's decline from its October 2007 peak was 56.8%, which had already priced in a scenario worse than any other bear market over the past 80 years, with the exception of the elephant in the room, which is the Great Depression. Our opinion has been and continues to be that while the current economic environment remains challenging, it is not of the same magnitude as what occurred during the Depression.
• The sharpness of the recent increase, though, even exceeded our short-term expectations. In a matter of about eight days the S&P 500 tacked on almost 20% and the Financial sector gained 50% (before pulling back slightly yesterday).
• Yet these types of moves are not without precedent. The last two rallies that occurred in late 2008 saw the S&P 500 rise 24% and 27%, respectively. Also, prior to the recent increase, the S&P 500's deviation below its 200-day average price reached 36%, which, while slightly less than the 40% difference witnessed late last year, was the most extended to the downside since the 1930s. As discussed in the past, much like a rubberband that continues to get stretched, an eventual snapback from such conditions can be sharp.

Figure 1. Prior To Recent Rally, S&P 500 Had Not Been More Oversold Since Early 1930s

Source: SunTrust Robinson Humphrey, Bloomberg

• The initial spark for the rally occurred when a number of large banks indicated their businesses were profitable in the first two months of 2009, reports the Securities and Exchange Commission (SEC) was considering restoring the up-tick rule (which bars investors from betting against a stock until it sells at a higher price than the preceding trade), and a review of mark-to-market accounting was taking place.
• Skeptical investors then attributed much of the recent rise in stocks to short covering as opposed to "real" buying by institutions, such as mutual funds and pensions. That may be true, but in our experience almost every rally begins this way, both those that have durability and those that eventually fail. Traders that are short, or betting that stocks are going down, are generally the participants most at risk when the market rises, and subsequently it makes sense that they are typically the first to buy stocks to cover their positions.
• Investor confidence has also been bolstered by some very tentative signs that the pace of the economic decline has started to moderate. This certainly does not imply the data is strong, but on some accounts it may not be getting worse, if that is any consolation.
• For example, the ISM index, which is used as a gauge of the economic health of the manufacturing sector, has shown subtle improvement over the past two months (though remains firmly in recessionary territory).

Figure 2. ISM Manufacturing DATA Shows Slight Improvement Over Past Two Months

Source: Briefing.com

Likewise, retail sales, which plunged in the fourth quarter, also bounced back over the last two months. The monthly data series is known to be volatile, so it will be important to see at least another good month to provide confidence that the recent action is more than a short-term blip.

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