What To Expect From This Bear Market Rally

Stocks rallied for the third straight week in what appears to be a classic bear market rally. Investors should count their good luck and use higher prices as an opportunity to reduce equity exposure or hedge stocks they don’t want to sell.

The Dow Jones Industrial Average (DIA) jumped by 367 points or 2.2% to 17,006.77 while the S&P 500 (SPY) rose by 52 points or 2.7% to 1999.99. The Nasdaq Composite Index (QQQ) rose 2.8% to 4717.02. The major averages have gained about 10% since their February lows, giving investors hope that the worst is over.

I do not believe it is. Despite some moderately positive economic news last week, the global economy remains depressed and the prospects for significantly higher stock prices are low. Let me explain.

Markets were encouraged by what they interpreted as strong economic data as well as signs that the oil price decline may be over. Friday’s jobs report, which was weaker than it looked, convinced them that the U.S. is unlikely to fall into recession this year. Earlier in the week, manufacturing data was modestly better than expected. And most important, oil price rose sharply this week, teasing the end of the energy collapse.

The Fed will Turn Good News into Bad News Again

Let’s assume for the sake of argument that they are correct about all of these factors. The problem with such a scenario is that, with a 4.9% unemployment rate and inflation ticking up toward its 2% target, the Federal Reserve is under increasing pressure to raise interest rates. Weak markets gave the Fed an excuse to delay doing so.

But a combination of better economic data and stable/rising markets makes it more likely that the Fed will increase interest rates sooner rather than later. They are unlikely to move this month but the odds of a June hike are increasing. And as we saw after the Fed raised rates in December, markets do not react well to such moves.

Higher rates would mean a stronger dollar, which would place downward pressure on oil price and corporate earnings in the U.S. The corporate credit markets have already raised the cost of capital for both investment grade and junk bond borrowers, which will further depress corporate earnings.