A long-awaited reversal in the monumental global stock market rally since early March finally arrived last week. As the first-quarter earnings season started winding down and post stress-test capital-raising weighed on some banks, investors were faced with a slew of gloomy economic reports suggesting the recent optimism about a global recovery might have been premature.

“This week, the hard economic data remind us that the global recession is ongoing: exports remain deep in the red; retail sales disappoint; inflation still volatile on food and energy but down on year; and industrial production declines. However, the data are consistent with the story of a slowing economic decline, foretold by several ‘green shoot’ survey reports,” said Rebecca Wilder (News N Economics).

Source: Tom Toles, Washington Post.

“Less bad” economic reports provided investors with little comfort, sparking a reassessment of their risk appetite and leading to profit-taking on most bourses. Also, commodities retreated after recording four-month highs earlier in the week, and high-yield corporate bonds and emerging-market currencies came off the boil. On the other hand, safe-haven assets such as government bonds, gold bullion, the US dollar and Japanese yen attracted buying. Investment-grade corporate bonds and Treasury inflation-protected securities also closed the week in positive territory.

The performance of the major asset classes is summarized by the chart below.

Source: StockCharts.com

After nine straight weeks of gains, global stock markets succumbed to profit-taking last week with the MSCI World Index falling by 3.4% (YTD +0.1%) and the MSCI Emerging Markets Index down by 2.4% (YTD +24.8%).

Similarly, the major US indices reversed course. The Nasdaq Composite Index (-3.4%, YTD +6.5%) and the Russell 2000 Index (-7.0%, YTD -4.7%) declined after rising for nine consecutive weeks and the Dow Jones Industrial Index (-3.6%, YTD -5.8%) and the S&P 500 Index (-5.0%, YTD -2.3%) fell after being up eight out of nine weeks.

After last week’s sell-off the Nasdaq is the only major US index still in the black for the year to date, finding itself in the company of the majority of emerging and mature markets.

Click here or on the table below for a larger image.

Returns around the world ranged from top performers Serbia (+10.0%), Cyprus (+9.7%), Bermuda (+9.5%), Namibia (+8.5%) and Vietnam (+6.5%) to Romania (-12.2%), the Czech Republic (-8.3%), Finland (-6.9%), Luxembourg (-6.9%) and Indonesia (-6.0%) which experienced headwinds. (Click here to access a complete list of global stock market movements, as supplied by Emerginvest.)

China (+33.3%), one of the leading stock markets for the year to date together with Brazil (+46.7%) and Russia (+94.6%), notched up another gain (+0.5%) last week despite disappointing economic data. A revival in Chinese property transactions has been a major contributor to China’s recent recovery in industrial activity. Good news for Chinese equity bulls is the close historical relationship between property sales and the performance of Chinese stocks.

Source: US Global Funds - Weekly Investor Alert, May 15, 2009.

With nearly all the US companies having reported first-quarter earnings, the S&P 500 saw earnings decline by 34.6% compared to the same quarter in 2008, reported Bespoke. At the start of the earnings season, a decline of 38.2% was expected. The percentage of companies lowering guidance was cut by more than half, while the percentage of companies raising guidance increased by over 70%. A tough second quarter undoubtedly still lies ahead, especially as companies will not have the advantage of non-recurring cost cutting.

John Nyaradi (Wall Street Sector Selector) reports that the strongest exchange-traded funds (ETFs) on the week were SPDR Russell/Nomura Small Cap Japan (JSC) (+6.1%), Market Vectors Agribusiness (MOO) (+5.4%) and iShares MSCI Chile Index (ECH) (+4.4%). On the other end of the performance scale KBW Bank (KBE) (-15.4%), iShares Dow Jones US Regional Banks Index (IAT) (-14.5%) and KBW Regional Bank (KRE) (-13.7%) were underwater as positive catalysts for the banking sector dried up.

As far as the economic sector ETFs are concerned, defensive sectors outperformed during the week, with Health Care SPDR (XLV) and Consumer Staples SPDR (XLP) leading the way. Financial SPDR (XLF) and cyclicals such as Consumer Discretionary SPDR (XLY) and Industrial SPDR (XLI) were on the receiving end of the selling pressure.

Source: StockCharts.com

Lower interbank lending rates indicated reduced strains in the financial system, as seen from the three-month dollar, euro and sterling LIBOR rates declining to record lows. After having peaked at 4.82% on October 10, the three-month dollar LIBOR rate declined to 0.83% on Friday. LIBOR is therefore trading at 58 basis points above the upper band of the Fed’s target range - a great improvement, but still high compared to an average of 12 basis points in the year before the start of the credit crisis in August 2007.

Gold bullion seems to be regaining its luster and again edged higher last week. “As sure as night follows day, the Federal Reserve’s purchase of bonds and home mortgages and the resulting rapid increase in bank reserves (quantitative easing in Fed-speak) - unless soon reversed - are underwriting a coming acceleration of inflation,” said gold specialist Jeffrey Nichols. “… by the time the broad financial markets register a worsening of inflation expectations gold will already have made a major move to the upside. It provides an early warning or leading indicator of inflation, signaling the coming acceleration long before financial markets begin to quiver.”

As to be expected, there is a strong relationship between the yellow metal (green line) and Treasury inflation-protected securities (red line).

Source: StockCharts.com

The quote du jour relates to whether the fact that bank stocks have rallied and in some instances been able to raise private capital, augurs an end to the financial crisis. Barry Ritholtz, editor of The Big Picture blog and author of Bailout Nation, a newly published and must-read book, succinctly remarked: “You can’t drink yourself sober and you can’t leverage your way out of excess leverage.” Many big banks remain technically insolvent and “are only being held together by spit, bailing wire and tape,” said Ritholtz in an interview with Yahoo Finance, Tech Ticker.

The banking system needs more time, at least three to five years, to deleverage before it can be left to its own devices, Ritholtz remarked, suggesting only time can heal the sector’s wounds.

In other news, the US Treasury announced that it would make $22 billion available to insurers from the Troubled Asset Relief Program (TARP), and the Obama administration sought new authority to bring transparency to the credit derivatives markets and also to crack down on the credit card industry.

Next, a tag cloud of all the articles I read during the past week. This is a way of visualizing word frequencies at a glance. Key words such as “market”, “financial”, “prices”, “banks”, “government” and “economy” again featured prominently. For the rest, it is really a bit of everything.

Back to the stock market. An analysis of the moving averages of the major US indices shows the spring rally having encountered resistance at the important 200-day line and/or the early January highs. The highs of May 8 are the most immediate target to the upside, whereas the levels from where the rally commenced on March 9 should hold in order for base formations to remain in force.

Click here or on the table below for a larger image.

A useful indicator of market breadth is a chart showing the percentage of S&P 500 stocks trading above their 50-day moving averages. Although this measure has declined to 78% from 92% in early May, it is still at a level typically seen at prior peaks during the bear market. This still looks overdone in the short term, but for a primary uptrend to manifest itself, the bulk of the index constituents should remain above the 50-day line and also trade above their 200-day averages (31% at the moment).

Source: StockCharts.com

Interestingly, Bespoke highlights that on a sector basis the percentage of stocks trading above their 50-day moving lines has fallen the most in Technology, Consumer Discretionary, Utilities and Financials. However, Health Care has actually seen its reading increase over the last few days as investors rotate from cyclical to defensive stocks.

For more about key levels and the most likely short-term direction of the S&P 500, Adam Hewison of INO.com prepared another of his popular technical analyses. Click here to access the short presentation.

Marc Faber, the author of “The Gloom, Boom & Doom Report”, wrote in his latest research report (via CNBC): “… I think that, at least in nominal terms (inflation-adjusted), the global printing presses being run by the world’s central banks and fiscal deficits have begun to impact asset prices positively. The lows reached by resource and mining stocks, as well as Asian equities and most emerging markets, are likely to hold for now.” But very high volatility and “price fluctuations that don’t appear to make any sense” will be the new dominant characteristic of the market, he warned.

Asking Richard Russell (Dow Theory Letters) what fundamentals he thought could cause the market to break the March lows, he replied: “You want guesses? Here are mine. (1) A collapse of the dollar along with a collapse in the bond market. (2) The US losing the reserve status of the dollar. (3) US consumers going on a long and unexpected buying strike plus a consumer saving campaign that shocks the economists and the Fed. (4) The Fed unable to halt asset deflation. (5) Federal budget deficits growing completely out of control, the compounding interest on the federal debt paralyzing the country with the catastrophic result that nobody will lend money to the US.”

According to the Telegraph, James Montier of Société Générale said prolonged suckers’ rallies tend to be especially vicious as they force everyone back into the market before cruelly dashing them on the rocks of despair yet again,” he said. Genuine bottoms tend to be “quiet affairs”.

“Teun Draaisma, Morgan Stanley’s stock guru, expects another shake-out, as reported by the Telegraph. “We think the bear market rally will end sooner rather than later. None of our signposts of the next bull market has flashed green yet. We’re not convinced the banking system has been fully fixed,” he said. He anticipates the new bull market to kick off later this year - perhaps in October - anticipating real recovery in 2010.

I am of the opinion that the US and other mature stock markets are in the process of mapping out a base development formation, which probably means toing and froing between policy tailwinds and economic headwinds.

But the “too-much-too-fast” rally made it inevitable for markets to either consolidate or retrace some of the past nine weeks’ gains prior to moving higher. Such a pullback as is now taking place is natural and necessary and should not be too much cause for concern, provided the levels from where the rally commenced in March hold.

For more discussion about the direction of stock markets, also see my recent posts “Stock markets: Reversal time?“, “Technical talk: Nasdaq in correction mode” and “Video-o-rama: Gloomy economic reports rein in investors’ optimism“. (Also, Donald Coxe’s webcast has been updated for May 15 and makes for good listening material. This can be accessed from the sidebar of the Investment Postcards site.)

John Mauldin’s “Conversations”
For those of you not familiar with John’s latest project (he is the author of Thoughts from the Frontline), it is called “Conversations with John Mauldin”. The most recent Conversation was with Gary Shilling and Donald Coxe, sharing in a rather lively debate their very different views on whether commodity prices will rise or fall. Previous Conversations included the views of Chris Whalen on the banking crisis, Lacy Hunt and Ed Easterling on the fundamentals of the economic crisis, and Nouriel Roubini.

Audios and transcripts of the Conversations are being produced. Although an annual subscription for a dozen Conversations retail at $199, I have negotiated a special price of $109 (-45%) for Investment Postcards readers. To find out more, just click here and enter code JM55 (at the end of the form), which will give you the discounted price.

Economy
“Global business sentiment has meaningfully improved since mid-March. The global confidence index remains consistent with ongoing recession, but the intensity of the downturn is abating. Most notable is a sharp gain in expectations regarding the outlook six months hence; it turned positive last week for the first time since the summer of 2007 just prior to the start of the current financial crisis,” said the latest Survey of Business Confidence of the World conducted by Moody’s Economy.com.

Jean-Claude Trichet, European Central Bank president, said on Monday the global downturn had bottomed out with some large economies already able to put the recession behind them and looking forward to renewed growth, according to the Financial Times. His remarks came as the Organization for Economic Co-operation and Development said there were signs of a “pause” in the economic slowdown in France, Italy, the UK and China.

Source: Financial Times, May 11, 2009.

“The economic free fall has been stopped, the collapse of the financial system averted. National economic stimulus programs are starting to take effect. The downward dynamic is easing,” billionaire investor George Soros was quoted as saying to a German newspaper (via Yahoo Finance).

“I expect the recovery to make up for around half of the downturn we have had and then to move into stagnation. Asia will be first out of the crisis, but America is also currently doing that,” he said.

The International Monetary Fund said the recovery would take longer than normal because the slump was precipitated by a worldwide financial crisis, expecting the global economy to contract by 1.3% this year.

Focusing specifically on China, the Financial Times reported “the total value of Chinese exports fell 22.6% to $91.9 billion last month compared with the same month a year earlier - a faster rate of decline than the 17.1% year-on-year drop in March”. However, Kevin (Sinolese.com) highlights that whereas total trade is down compared with March on an annual basis, this is because of a big increase from March 2008 to April 2008. ”When compared with the March number of this year, the result is positive. Not only so, total trade has been up for two consecutive months, with imports increasing faster than exports.”

Source: Kevin (Sinolese.com), May 15, 2009.

Turning to the US, a snapshot of the week’s economic data is provided below. (Click on the dates to see Northern Trust’s assessment of the various data releases.)

May 15, 2009
• The hike in core Consumer Price Index is temporary
• Factory production - moderation in pace of decline
• Consumer sentiment improves in May

May 14, 2009
• Auto industry shutdowns lead to jump in Initial Jobless Claims
• Food prices raise Wholesale Price Index

May 13, 2009
• Retail sales are stabilizing, but Q2 consumer spending should be weak
• Higher prices for petroleum imports lift overall import prices

May 12, 2009
• Small Business Optimism Index improves
• Trade balance widens slightly in March

May 11, 2009
• Fed’s program to purchase Treasuries, mortgage and agency securities - update

Also, RealtyTrac on Wednesday released its April 2009 US Foreclosure Market Report, which shows foreclosure filings - default notices, auction sale notices and bank repossessions - were reported on 342,038 US properties during the month, an increase of less than 1% from the previous month and an increase of 32% from April 2008.

Nobel Prize winning economist Paul Krugman argues that a rapid recovery is “extremely unlikely”. According to Bloomberg, he said: “Some of the measures that have been taken to deal with the crisis seem to be predicated on the belief that this is going to be a short, short recession. Everything says that’s wrong, that this is going to be a sustained period of weakness.”

Week’s economic reports
Click here for the week’s economy in pictures, courtesy of Jake of EconomPic Data.

Source: Yahoo Finance, May 15, 2009.

In addition to the Federal Open Market Committee (FOMC) releasing minutes of its April 29 meeting (Wednesday, May 20) and the Bank of Japan announcing its interest rate decision (Friday, May 22), the US economic highlights for the week include the following:

Source: Northern Trust.

Click the links below for the following reports:

• Wachovia’s Weekly Economic and Financial Commentary (May 15, 2009)

• Wachovia’s Monthly Economic Outlook (May 2009)

• Wachovia’s Global Chartbook (May 2009)

Markets
The performance chart obtained from the Wall Street Journal Online shows how different global financial markets performed during the past week.

Source: Wall Street Journal Online, May 15, 2009.

Elroy Dimson, professor at the London Business School, said: “Risk means more things can happen than will happen.” Hopefully the “Words from the Wise” reviews will assist Investment Postcards readers in taking informed decisions to make sure “fewer things” happen to their investment portfolios.

Click here for some more thought-provoking news items and quotes from market commentators.

That’s the way it looks from Cape Town (where we are enjoying balmy autumn days).

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Source: Dilbert.com (via Barry Ritholtz’s The Big Picture).

* Dr Prieur du Plessis is chairman of Plexus Asset Management and writes the Investment Postcards from Cape Town blog (www.investmentpostcards.com)