Beware of the Hope Rally

This week started out with a pause in the recent market rally. However, today the play button on the rally seems to have been pushed once again. I think Monday’s pullback makes sense, especially in the context of the big run we’ve seen in stocks during the past four weeks. I also think that we could see a continuation of this bear-market rally, possibly all the way up to the 200-day moving average.

From a historical perspective, a run-up to the long-term moving average makes perfect sense. In the chart below of the S&P 500 during the bear market of 2000-2002, there were several occasions when stocks rallied off of their lows either to just below, or just above, the 200-day moving average.

I consider these sharp bear-market moves to be what I call "hope rallies." What this means is that investors are hoping the worst is behind us, and they are hoping that stock prices will be higher several months down the road.

If we take a look at the chart below of the S&P 500 during the past 12 months, we instantly see just how far this market has to go to return to pre-bear market levels. Of course, you also can see the strong recent surge in equities.

Despite the recent strength in stocks — and the possibility of a continued hope rally — I think the market is still confronting a host of nasty negatives. In fact, I think the U.S. economy still has a long way to go before it rights the ship of rampant debt creation, surging unemployment and contracting consumer spending. Then there is the real estate market, which continues its rapid deleveraging — both on the housing front, and the commercial front.

And speaking of that rampant debt creation, let’s review just how much new debt is being taken on by the federal government, a.k.a., you, me, our children, our children’s children, and so on.

Under President Obama’s budget, the non-partisan Congressional Budget Office (CBO) projects that the national debt will soar during the next 10 years from 40% of GDP today to an incredible 82.4%. By comparison, when President Reagan left office, the national debt was 42% — a number that I think is way too high, yet is still only half of what the CBO projection is a decade from now.

The president’s budget also states that total federal borrowing will grow by $2.7 trillion this year alone, an increase of 27% in one year. It’s almost unfathomable to think that the budget President Obama has proposed for this year increases federal spending by a whopping 34% during the previous year, with a total of $4 trillion (with a "T") in federal spending.

I fear that this massive debt crater our leaders are digging the country into will have significant consequences for the economy and the stock market in the years ahead. These consequences won’t be positive for the bulls, and it’s another reason why I advocate approaching this market with extreme caution.

I think it is very important for you to remember that our economy is still in the midst of the greatest storm since the 1930s. History shows us that troubling economic times don’t follow a path straight down. As we’ve seen, strong bear markets are replete with so-called "fits and starts," occasions where stock prices re-test their lows before moving upward. This latest rally is one of those starts, but I suspect the market will be back to having fits sooner rather than later.

When those fits will start is anyone’s guess, and that means if you are going to wade into these treacherous market waters, you must do so with a strict sell discipline — and with a strong constitution that’s ever intrepid in the face of loss.