The stock market rally continued last week despite the fervent desires of those underinvested and those selling short. Markets always seem to act in ways that frustrate the maximum number of traders/investors and this market is no exception. It seems that the news, no matter its content, is perceived in this market as positive. Bank passed the stress test? Bid it higher. Bank failed the stress test? Bid that one higher too. Lost 500,000 more jobs last month? No worries, it could have been worse - buy!

A few weeks ago, finding someone bullish on this market was harder than finding Arlen Specter’s principles, but now the only thing more prominent than the green shoots and mustard seeds of recovery are the horns sprouting atop former bears heads. The American Association of Individual Investors poll this week found a plurality of the respondents (44.1%) in the bullish camp for the first time in quite a while. A full third are still steadfastly bearish and 22.6% are firmly planted on the fence, so the majority is still a bit skeptical, but confidence in the rally is expanding. Other measures of fear are also falling rapidly with the volatility index (VIX) hitting its lowest level since September.

While the fear has subsided, the VIX is still elevated so there might be some upside left in this market, but it seems likely that the easy gains have already been seen. The professionals that trade in the S&P futures are also in transition. They have been long the futures during this rally while the small traders have been short, but last week saw the large speculators liquidating longs and adding to shorts while the small traders did the reverse. In other words, the professionals are selling to the amateurs. In my book that’s a very large warning signal. The pros are still net long, but the difference is narrowing sharply.

Another worrying sign is that insiders are using this rally to lighten up on company stock. In April insiders sold 8.3 times as much stock as they bought and as Alan Abelson at Barron’s said recently, nobody ever sold a stock because they thought it would go up. Some have tried to explain this away by saying that the insiders are selling because, like everyone else, they need to deleverage, but that seems a bit hopeful to me. If they’ve held on this long and they thought the stock was going higher, wouldn’t they wait another month or two?

The economic outlook has certainly improved over the last two months (see our economic outlook) but it is probably asking too much for things to improve in a straight line. Individuals and corporations are still deleveraging, a process that will take years, not months. Consumer debt is falling and while that is a good thing in the long run, it means lower consumption now. Companies still need to get their production and inventories matched up at this new lower level of spending and seem unlikely to be hiring lots of the same workers they just laid off anytime soon. Government is trying to fill that gap, but as anyone who has dealt with government knows, nothing happens fast in the public sector. So while I expect that a Fed induced recovery will manifest itself sooner than most expect, I also expect to have some setbacks over the next few months.

In the very short term, investors have gotten too enthusiastic about the prospects of recovery, so a correction of some kind would not be surprising. With the S&P 500 nearing my target of the 200 day moving average, I am getting more cautious:

It is possible that the market does not correct here and just keeps going up through my target. And being a believer in an early recovery (regardless of the quality of that recovery), I would also tend to use corrections to increase our exposure to stocks. But the higher the market goes on this rally, the bigger the correction will be when it eventually comes. Even if this is a new secular bull market (which I doubt; this is cyclical), corrections of 10% are fairly normal and larger corrections that give back 1/3 to 1/2 of the recent rally would not be surprising. Bear markets rarely end in V shaped recoveries; it takes more than two months to make a bottom.

More interesting at this juncture are the commodity markets. The commodity indices have not had as big a rally as the stock markets, but do appear to have made a bottom:

If the economy is really bottoming out, commodity prices should rise as economic activity picks up. Considering the source of the recovery is primarily monetary, it also makes sense to see money flowing into real assets. Inflation, as Milton Friedman taught us, is always a monetary phenomenon and it shows up first in commodity prices. The dollar is falling again and that is a source of support for commodities priced in a devaluing unit of account:

REITs have also had a spectacular rally off their lows, with prices up over 50%. Real Estate also performs well in an inflationary environment when the dollar is falling:

If the dollar keeps falling and commodity prices keep rising, that may be the source of the stock market correction. While most have seen rising oil prices recently as a sign of economic improvement, at what point does it become a headwind for recovery? Remember, last year when prices were racing to $150, stocks tended to react negatively to rising prices. That non correlation will reassert itself at some point. I raised our exposure to commodities and foreign bonds in the last week based on my expectation that the value of the dollar will eventually succumb to the Fed’s over exertion of the printing press:

To sum up:

• Stocks are overdue for a correction and it could come at any time.
• The dollar appears to be resuming its downtrend and commodity prices are responding on the upside.
• REITS are also showing signs of recovery.
• The economic outlook has improved but the economy continues to contract.