Market rallies after mid-November?

JP Morgan Equity Strategists expect to see a rally taking hold after mid-November and a higher finish by year end:

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• Reason #1: 86% of bottoms have a retest. 75% of retest windows passed by 11/23/08. A large number believe the “low” was set on 10/10, when the S&P 500 fell to 839 intraday, representing a 46% decline peak to trough. If 10/10 indeed proves to be the low, a retest is almost a certainty. As shown in Figure 3, since 1900, retests are the norm, occurring 86% of the time. Applying those past retest windows to the 10/10 “low,” we arrive at some dates that could be important. By 10/26, we passed 25% of retests (see Figure 3). By 11/23/08, we should have passed 75% of retest windows (see Figure 3 and Figure 4). The furthest out to see if 10/10 holds is to 1/22/09, which is the 2002 lows. Three bottoms had no retest, 1917, 1942, and 1949.

• Reason #2: 20-day intraday volatility can fall below 3% only after mid-/late-Nov. Intraday volatility, a measure we are watching very carefully (see Figure 5-Figure 6), is calculated as [(high – low)/close] on a 20-day basis. High intraday volatility, in our view, sidelines major institutional investors. Intraday volatility rose to over 7% on 10/29 and receded to 5% currently (it is falling) but is still above 3%. If current trends persist, intraday volatility will dip below 3% after 11/23 (20D avg). The surge in intraday volatility (inverted scale) above 3% has been associated with the major lows of 1987, 1998, and 2002, as it captures the panic, liquidation, and risk aversion needed to see a low.

• Reason #3: 45-day redemption window for Hedge Funds is 11/15. Finally, the 45-day redemption window for some hedge funds (for 12/31/08 redemptions) is 11/15. This issue has been widely discussed, and at this time actual data are not yet available. Investors have been watching this window carefully for obvious reasons. To the extent that funds have anticipated redemptions, this explains some of the selling we are seeing. Additionally, no investor wants to add risk during a time when there is such an imbalance of sellers. Thus, we think investors are likely to wait for this window to clear before adding risk. Unfortunately, one of our associates in Europe has noted that a large number of hedge funds have 30-day redemption windows, which means additional redemptions could be seen then. Again, the reason this matters this year is the extreme volatility and correlation of assets have caused hedge funds to perform worse than in past downturns.

Net-net: The extremely high volatility argues against adding risk, and, as we noted above, we see a better window after mid- to late-November. Disinflation, we believe, remains sizable, favoring industries with high input costs and hence, we see Airlines as well positioned. On the other hand, we remain negative on the “inflation shock” sectors, Energy and Materials. At some point, we see a rally, and we affirm our YE target of 1,125.

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