Stock Market Rally: 3 Reasons Why it Won’t Last

It’s all over. Stocks are back. The Dow roared back to life in record fashion yesterday. After the worst sell-off in decades, it’s time for a tremendous rally.

Will it last? Is it time to buy?

It’s a tough time to be an investor. Frankly, there is still a lot of uncertainty in the market despite yesterday’s rally.

The CBOE Volatility Index (VIX), which is a good indicator of the level of fear in the markets, still sits well above its previous decade highs.

On top of that, closed-end funds tell an equally bearish story. A closed-end fund trades like a stock and holds a group of securities that are tough for individual investors to buy. For instance, some hold distressed debt, municipal debt, or China’s “A” shares which only Chinese citizens are able to buy. They will also trade at a premium or discount to relative shares.

Almost every closed-end fund is selling at a very steep discount to Net Asset Value. There are about 654 closed-end funds traded on major exchanges. As of Friday, 636 of them are selling at a discount. Only 18 are fetching a premium.

The discounts run deep too. Some high income funds that are loaded with junk bonds and real estate funds are trading at discounts as high as 55%.

The current sell-off is unprecedented…but, it’s probably justified. The markets may be recovering over the next few days, but the recovery is not sustainable.

As we’ve focused on here throughout this entire mess, there are so many roadblocks out there. The odds of a sustained rebound and the emergence of a new bull market appear to be years away. It’s all because of the economy.

The sell-off over the past two weeks has been a rough one. At the end of it all, we can now see the last great source of wealth, the stock market, was decimated. As a result, all three sources of wealth that have fueled American consumers are gone. We’re entering a long hard recession and it’s best to gear up for at least a year of hard economic times and relatively flat market performance. Here’s why.

The American economy is completely consumer-based. Most estimates range between 65% and 75% is driven by consumers. Consumers have felt very wealthy for a long time, but now that’s coming to an end. The three primary sources of “wealth” in the United States (stocks, real estate, and credit) are all in decline.

Stock Market Wealth

Despite yesterday’s rally, the markets are still down 33% since its highs set a year ago. The Congressional Budget Office reported that $2 trillion was wiped away from retirement and 401K accounts in the United States in the past year.

That’s a lot of wealth that has disappeared. And it will have a big effect on the economy.

Consider this, 61 percent of Americans are currently invested in the stock market. Sure, according to the mutual fund flows we track a few were able to pull out early. Most investors, however, held tight or took their losses at or near the most recent bottom.

The wealth effect that has been created by the stock market has been nearly eliminated. After all, how many people who just watched 30% of their portfolio value disappear are going to think, “You know what, this is the time I really need to upgrade from a 56-inch LCD TV to a 64-inch model.”

It’s just not going to happen (Personally, I’ve started buying some put options on retail outfiest like Best Buy (BBY). The collapse in retail is about to begin.)

Real Estate Wealth

During the market downturn in the early 2000’s, the stock market decline was a significant drag on the American economy. The bursting of the dot-com bubble wiped away $6 trillion of wealth. But there was one popular asset that was actually increasing value, real estate.

Between 2000 and 2002, owner’s equity in real estate increased 20%. So while the markets were imploding, some of the losses were offset by a significant rise in real estate values. That’s why that recession was one of the softest landings on record. This time, real estate prices are down about 20% across the board and falling further.

Credit Card Wealth

Finally, the last hope for keeping consumers temporarily afloat is credit cards. All signs point to this source being completely dried up.

Over the past few weeks credit card companies have slashed the amounts they are willing to lend to risky customers. Most of them won’t even open up new accounts for high-risk individuals. And they cut their marketing budgets too. According to CBS News, HSBC sent out 54% less direct mail advertisements and Citibank has sent out 45% less.

The credit card issuers have become risk averse and are finally limiting the total credit available and the amount of customers they’re willing to take on. Credit card spending, the third leg of American “wealth,” is going away too.

There’s just not much going for the consumer and I expect this to cause a significant drop in consumer spending. As of last month, the experts still expect holiday spending to increase more than 2% from last year. That’s significantly less than the 5% to 6% growth over the past two years, but I still think it’s overly positive.

Where will consumers get the money? And if they do get the money, how many will be willing to spend it? After all, employment is on the rise and will continue to rise.

Frankly, the bailouts mean very little to the markets. They will relieve the panic selling and keep the nation’s financial system intact, but they’re not going to get this market turned around. The economy is set up for a major contraction.

Whether this is a sucker’s rally or turns out to be a sustainable rally that closes the door on the buying opportunity of a lifetime remains to be seen. Odds are it won’t last. We’re starting a recession instead of coming out of one and corporate earnings will decline.

Unemployment is rising, consumer spending is grinding to a halt, and people will be forced to start tapping their investment accounts just to get by, there will be more selling pressure on stocks to come. I expect there to be ample time to pick up stocks on the cheap over the next two years.

The stock market will eventually pick up when we the economy starts to turn around, but that’s probably more than a year away.

Martin Whitman, who’s Third Avenue Value Fund [TAVFX] averaged a 16.83% annual return from 1990 through 2007, recently said, “This is the opportunity of a lifetime.”

He’s probably right, and this downturn will go down in history as the buying opportunity of a lifetime. But I’d advise against going “all in” now.

Given the state of the economy and how much has to be worked through, a buying opportunity that only comes along once in five lifetimes could be around the corner. It’s best to wade in using a dollar-cost averaging strategy to capitalize on the current opportunity as well as any that come down the line.

I’m not going to tell you the markets are going to rise tomorrow, or they’ll be down. But I can tell you this: It is times like these, when everyone is losing their heads and running for cover, that the seeds of true wealth and financial independence are planted for prudent investors.

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