A rally is overdue

A bearish air now pervades financial markets as even the secretary has started using the R word (recession). Yet historically it has often been profitable to stick your neck out when everyone else has been hiding. Even in extended bear markets (which we are likely experiencing), it is not unlikely to see markets rally 20% before falling back again. Managers point to three stars that have recently aligned that could make way for rally.

1. Sentiment:
A way to measure capitulation by investors (at least in the short-term) is the VIX index. The understanding is that high (and unexpected) volatility brings about forced sellers – a huge sell-off then would lead to a peak in the index. However forced selling leads to oversold markets. Although the VIX index has yet to reach the heights of 1998 and 2003, where it breached the high 40s, the recent peak suggests another short-term rally is under way.

An interesting graph taken from the Morgan Stanley Fund manager survey shows that most fund managers are overweight cash. Even more so than during the early part of the decade. This firstly shows how much pessimism is already discounted in the market, and secondly it is a vital source of liquidity for a prolonged rally.

2. Valuation
We know that valuation levels are looking very attractive again. Consider the equity dividend yield on the FTSE All Share, which is now yielding close to the 10-year GILT. The last time dividend yields have breached the yield on GILTS was back in early 2003, which we know was just the start of the bear market rally.

3. Catalyst
The only ingredient missing to another rally was for oil prices to come off. The recent fall in oil prices can provide the final catalyst for markets to start rallying from this point.

I think it may be worthwhile to look to the sky for signs, and surely it is telling us that a rally is under way.

Your optimistic about the short-term analyst
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