Glimmers of hope for the economy have shown up over the last two weeks

As I have been writing in recent columns, investor sentiment had gotten extremely bearish and fearful, which is always the case at significant market lows. On the technical side, the major market indexes were extremely ‘oversold’ beneath their long-term 200-day moving averages. Short-selling had been at a feverish pitch. 

However, once such conditions for a potential rally have been set up, what is always needed is a catalyst – some event, announcement, or a glimmer of improvement in economic reports – to convince short-sellers to begin moving to the buy side to take profits from their short-sale positions.  

Once a ‘short-covering rally’ begins – and that is how most rallies off of oversold conditions begin – the rising market begins to entice short-term traders in on hopes for quick profits from at least a short-term rally of a few days. And the rally continues. 

But whether the rally can continue still further into an intermediate-term rally of several months duration depends on whether institutional investors (large pension plans, insurance companies, etc.) have reason to believe the rally will continue.  

And if they keep the rally going still further, individual investors, whose fear levels created the extremely bearish investor sentiment, will gradually lose their fear and join in, providing more fuel.  

And thus does a rally begin, continue, and usually not end until the market has become ‘overbought’ above key moving averages, and until investor sentiment has reached the opposite extreme of high bullishness and confidence usually seen at rally tops. 

Sounds so easy to recognize.  

But it is not. The market always looks six to nine months ahead, topping out when surrounding conditions still look great and it seems like they will continue that way, and bottoms when surrounding conditions look horrible and it seems they will only get worse. Therefore, there is always skepticism in the early stages of any rally, fear that it is a trap – and obviously sometimes it is.  

Even more problematic, since the market moves six to nine months ahead of the economy, even when a real rally has begun economic conditions will continue to worsen, and the market will have to climb that proverbial ‘wall of worry’. 

So how does all that tie in with the current situation? 

There is no end of differing opinions, but I believe the substantial rally I have been expecting since investor sentiment became so extremely bearish, and the market became so extremely oversold, has finally begun. 

Regarding the need for a catalyst, glimmers of hope for the economy showed up over the last two weeks. 

For instance, the previous rally attempts in January and February immediately ran into fears that General Motors or a major bank or two were going to fail. But that fear has diminished with the growing thought that bankruptcy might be the best choice to get their situations resolved more quickly. 

Then there was the report from CitiGroup that after posting five quarters in a row of operating losses, it is operating at a profit so far this quarter. The operating profit will probably be wiped out by special charges and write-offs, but it is an indication that some of these troubled banks will be viable ongoing concerns if the toxic assets on their books are taken care of. 

Meanwhile, the important psychological side of the problem, the consumer and investor fear induced by unending gloomy speeches and headlines, is being tackled, with at least some encouraging talk from the likes of Fed Chairman Bernanke, Treasury Secretary Geithner, and large investors, now willing to predict the economy will bottom later this year and begin to recover slowly next year. 

Also gone away are the selling pressure of January and February when hedge funds were selling heavily to raise cash to meet record levels of investor redemptions at the end of this month. Since hedge funds only allow investors to take their money out of the fund at the end of each quarter, and require a 30-day notice, the period for redemption requests for this quarter has now gone by. 

And so far, unlike the previous ‘one-day wonder’ rally attempts, this time there was some follow through over the next couple of days, with the market heading toward its most profitable week in a long-time as this is being written mid-day on Friday. 

Most analysts are worrying that the economy continues to worsen, that there will be no improvement in the economy for months, and so the market cannot have a sustained rally at this point. They are apparently forgetting that the market looks ahead. If a rally of several months duration has begun, and they wait until the economy has improved to believe it can continue, they will have missed much of the rally.  

That skepticism actually supports the idea of a sustainable rally, as people only slowly and belatedly become converted to bullishness, keeping the money flowing in over a longer period of time.  

We shall see.