Don't Be Fooled by Rallies: Rough Road Ahead for Stocks

To those roiled by the wild stock swings over the past several weeks, the market is sending a clear message: Strap in, it's going to be a bumpy ride.

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While the good news is that the market has recovered most if not all the losses it suffered at the early part of last week, the bad news is this is how bear markets behave—with wild swings and counterintuitive behavior that makes forecasting near-term moves a messy endeavor.

"It's really a waiting game and a push-me pull-you between the bears and the bulls where you're going to have up 100-down 100, up 200-down 200 days until this stuff is resolved," said Michael Cohn, chief market strategist at Global Arena Investment Management in New York. "We're definitely in a recession of confidence, and that's what it's all about—confidence."

The market is currently on a five-day streak of 100-plus up or down days—likely headed for a sixth on Monday—on the Dow Jones industrials as investors weigh a worsening economy, a US debt downgrade from Standard & Poor's and an unprecedented move from the Federal Reserve to keep interest rates near zero for at least the next two years.

In that period the market rallied more than 600 points in just more than an hour following the most recent Fed announcement. The day before the index dropped 635 points and the day after it fell 520 points before steadying into the end of the week and spiking again Monday.

The most recent template, though, for such behavior is not the last bull market but rather the last bear—in 2008 at the apex of the financial crisis. During that time, the Dow jerked ahead 779 points in one two-day period in September and also posted single-day gains of 485, 936, 889 and 1,253 points even as the financial system crumbled.

"This whipsaw trading is not typical of a bull market," Mary Ann Bartels, technical research analyst at Bank of America Merrill Lynch, wrote in a note. "The last time in history we saw these volatile movements were in 2008, 1987 and in the 1930's-early 1940's...The risks are increasing for a recession , which we believe the equity market has already begun to price in."

In such an environment, the consensus belief is growing around a trader's market where the short-term gyrations present opportunities to buy beaten-down stocks and sell them as they recover.

"We're so news- and headline-driven," said Ryan Detrick, senior analyst at Schaeffer's Investment Research in Cincinnati. "Very short-term also. This volatility is probably here to stay at least for the intermediate term. What would it take to calm things down? Some major resolution in Europe. It doesn't feel like we're close to anything there."

For a trader like Detrick the opportunities are in small-cap stocks as well as gold and silver. Of course, things can change very quickly and investors will be looking closely for the next catalyst.

That could come when Fed Chairman Ben Bernanke delivers his much-anticipated addressat Jackson Hole, Wyo. on Aug 26. Bernanke used the speech last year to lay the groundwork for what would be called QE2—or the second round of quantitative easing in the form of $600 billion worth of Treasurys purchases.

"We think the market has further work to do on the downside over the longer term," Charles Biderman, CEO at market research firm TrimTabs, said in his weekly analysis. "The wild card is obviously the Fed, particularly with the anniversary of the QE2 announcement less than two weeks away. Even if QE3 is announced, however, how long will the likely rally last?"

With questions over how effective yet another round of easing will prove, TrimTabs is advising clients to stay in cash with allocations to metals and other commodities as well as inflation-indexed bonds.

"In our view, the Federal Reserve’s money printing is the main reason the S&P 500 just about doubled from March 2009 through June 2011," Biderman wrote. "Now that the Fed has stopped goosing the markets, stock prices have tanked. We do not see any source of money to take stock prices higher."

Among telltale signs the firm cites for its cautious approach is a record $46.9 billion outflow in August from stock market-based mutual funds—a move that could be bullish from a contrarian perspective but also signifies how much investors have lost faith in the market.

"We suggest using rallies to raise cash and or become more defensive until our trip wires to a bottom generate a buy signal," Bartles, of BofAML, wrote in her note.

To be sure, long-term investors are also seeing opportunities.

But that's predicated on the willingness to withstand the moody markets.

"Volatility is the friend of a long-term investors because he or she can take advantage of it if they have a strong stomach to buy stocks when they are getting crushed," said John Buckingham, chief investment officer at Al Frank Asset Management in Aliso Viejo, Calif. "You can actually move up the quality spectrum and get a nice dividend yield out of your portfolio and take advantage of undervalued stocks."

But with the Fed still looming and high-speed trading adding to the sudden accelerations of the market in either direction, the trend will not be smooth.

"So you're relegated to playing the QE game to some degree. That's the game you can play if you still want to have some chips on the table," said Cohn, from Global Arena. "Until you can see some sort of light, it's better to play it safe."