A Rally Without a Reason Is Just Market Noise

It's a new bull market! Stocks are up more than 20% from the lows, in just three weeks. But is it really time to declare “all clear"?

The move in stocks is extremely encouraging, and should be taken seriously. But let's not get carried away.

For one thing, even though many analysts use a 20% rise as their threshold definition of a bull market (just as they use a 20% loss to define a bear market), we shouldn't get hung up on arbitrary numbers. Besides, with stocks at historical levels of volatility, moves like 20% can just be noise, not signal.

Also, let's keep this in context. It's terrific we've had this rally over the last three weeks, but it would still take more than another 7% on the upside for stocks to catch up with where they were at this point in the Great Depression. That's right, what I wrote three weeks ago is still true: Believe it or not, 534 days from the October 2007 highs, the 46.8% drop in stocks is still worse than the 42.9% drop the same number of days from the highs of 1929.

So we have to ask ourselves the critical question: Why? What has caused stocks to make this sudden recovery? If there's no reason, or if there's a bad reason, then we should just write this move off and figure we're in a bear market rally.

A major explanation of this big three-week rally is simply that, three weeks ago, stocks were insanely cheap. At the very lows, they were 56.8% off from the October 2007 highs, making this the second-worst bear market since 1900. Things may be tough in this economy, but they're not that tough. Stocks were simply oversold.

Relying just on that, it makes sense that stocks have rallied, and there's no particular reason to expect they'll give it all up now. After all, if they were so insanely cheap that they had to correct higher, then they're not likely to suddenly become that cheap again unless the economy gets a lot worse.

That suggests another explanation. Are stocks telling us that maybe the economy is actually getting better? My friend Larry Kudlow keeps talking about “mustard seeds” of recovery. And now Fed Chairman Ben Bernanke is talking about “green shoots.” Maybe there's something to it.

For sure, the economy has stopped acceleration to the downside. Home sales are accelerating. Consumption has recovered substantially from the horrible Christmas season. Monetary deflation has stopped. Job losses have stopped getting worse. And earnings downgrades have stopped getting worse.

None of that is evidence of any kind of roaring recovery. But to get any recovery at all, first you have to stop getting worse. Then you have to stabilize. And then you can recover. It was just a few short months ago that it seemed that the economy was just going to spiral all the way down to zero — at least that's not happening, and it's an important start.

Another very real explanation of what's happening here is the toxic asset plan announced on Monday by Treasury Secretary Tim Geithner. After his miserable debut last month with a half-baked plan that made no sense and had no specifics, his coherent and ambitious plan revealed Monday is a sign that he really is a competent economic technician — and it's a very good thing to have a Treasury secretary who's not a total bozo.

But more than that, one critical element of Geithner's plan allays one of the worst fears that investors were harboring — the risk that Geithner would make some overreaching move to “nationalize” the banks. This plan is anything but that. It's a real rescue. Not a nationalization. Not a punishment. That's quite a relief, especially in a berserk political environment in which it seems that most politicians want nothing more than to hang bank executives from the nearest oak tree.

You'll hear lots of commentary that Geithner's plan is a “subsidy,” or a “giveaway.” Well, it is. And that's what I like about it. If we're going to rescue these banks without destroying them, it's just a fact of nature that we're going to have to spend some money on it. So get over it. Do you want to save the system, or don't you?

And the plan ought to work. In a nutshell, it calls for lending money to investors to buy the so-called toxic assets that banks haven't been able to sell. The terms of the loans are extremely generous — especially the fact that they are “non-recourse.” That's banker-speak for: If the toxic assets turn out to be worthless, you don't have to repay the loan — just give the government the toxic assets themselves, and walk away.

So the government is putting up the money. The government is taking the risk. What's not to like? I'll do that trade all day long, and so will lots of people. A couple months from now, toxic assets are going to be the most popular securities in the marketplace.

That's why stocks soared more than 7% on Monday when Geithner announced the plan, and why they've moved up further since then.

But is that enough to give birth to a whole new bull market? Is there any more upside from here?

I think there is, but I'm not getting carried away about it. There are still a lot of very worrisome factors that, I think, will end up capping the upside. Even if we don't end up ever making new lows below the ones we made three weeks ago, the lack of a really viable upside from here makes this rally not all that attractive a proposition.

The biggest negative factor remains the one I've been talking about here for several weeks — basically, the Congress. It seems bound and determined to make it impossible for anyone to make any money. And if they do, to tax it away from them.

Suppose you agree with me that Geithner's plan is a great investment opportunity, and you borrow from the government to buy toxic assets. Let's say everyone goes perfectly, and you end up making a ton of money. You think Barney Frank and Christopher Dodd and Nancy Pelosi are going to let you keep that money?

No way. You'll be branded a greedy capitalist pig who got rich on the taxpayer's dime. There will be hearings and show trials, and you'll be dragged through the mud, and the editorial pages of the major newspapers will demand you give the money back. And if you don't, they'll slap a 90% tax on it.

So, fine. This is a nice rally, and it could continue for a bit. But “a bit” isn't really a whole new bull market, is it? In a bull market you get to keep your profits.