'Valley after rally' looming?

by Stephen Butler

What next? While the stock market may be taking a breather, could another shoe be dropping soon?
Pick your poison - the next round of resetting adjustable-rate mortgages, a credit card default wave, small banks with mortgages on empty commercial property, still-rising unemployment - there's plenty of bad news if you just look hard enough.

Meanwhile, what's so is that every substantial rise in the stock market has been followed by at least some testing of the lows. It's the market saying, "Is this for real?"

Turning to some tea leaves, we can start with a look at history. The "Valley after the Rally," as pointed out by Paul Lim in The New York Times, has seen a lot of variation over the years. A rally after a bear market low always retests the low sooner or later. The market typically declines for awhile as part of a natural digestive process after gorging on a substantial gain. Practically speaking, it can be an exercise of profit-taking by investors who have had enough and who have been waiting to be made at least partially whole before throwing in the towel.

The easy money has already been made over the past eight weeks. Now comes the heavy lifting as the market lurches forward and possibly retests the market low. Regardless of what happens over the "summer doldrums" when a thinly-traded market traditionally slumps, we have history on our side. After any 10-year period when the market ended with a return of less than 5 percent, the following 10-year period saw average returns of anywhere from 7 percent to 13 percent. We are teeing ourselves up for a modicum of success by any historical standards. Money compounding at 10 percent doubles every 7.2 years, if that's any consolation; but even at a modest 7 percent return, your current account balance stands to double in about 10 years.

For crystal ball purposes, the VIX (Volatility Index) and the Baltic Dry Index (don't ask) are two forward indicators that can give us some idea as to how we might fare in the months ahead. The VIX is a measure of the amount of volatility in the options markets and it reflects the level of uncertainty on the part of professional investors.

A high VIX (at 80) like we had last fall is usually followed by a decline in stock prices. Today the VIX is around 40. The VIX was at 20 during the rise in 2002.

Apart from the VIX is the Baltic Dry Index. This is the index that reflects the amount of shipping trade in the immediate future around the world. It is a measure of how much raw material is about to be shipped, and this, in turn, offers a glimpse into how much in the way of goods will be produced worldwide --- presumably to be sold at a profit. For what it may be worth, the Baltic Dry Index has quadrupled in value over the past few months. In lock step, Dreyfus Greater China fund has doubled since March 4th. Another 100 percent gain since March has been enjoyed at T. Rowe Price Emerging Markets Stock fund.

We don't need to torture ourselves by wondering why we didn't act more aggressively back in March when the world was going to hell in a hand basket. It takes nerves of steel to consider investing s in a plunging market --- it's like trying to catch a falling knife.

However, the more risk we can accept, the greater the rewards will tend to be. Over time, the invisible hand of economic forces produces a "risk premium" that generates higher returns for investors who can live with more volatility. It stands to reason that human nature would behave this way, because otherwise there would be no money ever available for smaller companies or for promising ventures in the world's banana republics.

Considering that some of our retirement money will still be in play when we die, we can take the long-term view for at least some portion of our investments. If the renowned "valley after the rally" becomes a reality over the next few months, some of us might consider it an opportunity to shift a small portion of assets into something more entertaining and dramatic than the usual collection of bonds and blue chip stocks. At the reading of the will someday, our heirs will be amazed at our foresight.

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